Do you agree with HSI’s conclusion that the indefinite investment exception under ASC 740-30 should continue to be applied?
The Accounting Standards Codification (ASC) 740-30 provides disclosure as well as an accounting guidance for companies with limited exceptions on ways to record deferred taxes. These exceptions relate to how subsidiary companies and joint businesses can file deferred taxes that arise from undistributed earnings. Simply put, subsidiaries belonging to US companies are taxed in their host countries and are not taxed in the US if the indefinite reversal is met. Thus, they are not required to record deferred taxes if the indefinite reversal criteria. However, if the indefinite reversal fails to apply, the companies must file deferred taxes and get taxed according to their earning at the time of recording. At times the presumption of undistributed earning being moved to the parent organization is overcome by firms, and they will not be required to pay income taxes if the indefinite reversal criteria apply. The company is expected to prove that the affiliate company has capitalized all the undistributed earnings or the proceeds have been transferred to the parent company through a liquidation that is not taxable.
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The Financial Accounting Standards Board (FASB) 740-30 subsection 25-17 additionally provides a guideline on how undistributed earnings will be recorded (Proestakes, 2017). As stated, the presumption of undistributed earnings being moved to the parent firm may be achieved without income taxes becoming accrued. The parent company will have to provide proof of plans to reinvest the undistributed earnings of the subsidiary company. Parent company’s experience, remittances and future processes are the required evidence for overcoming the presumption. However, this provision provides loopholes that companies can exploit to avoid remitting taxes.
The two years 20X2 and 20X3 present two main events. In 20X2 there was a cash distribution to the US parent companies from the European subsidiary firms. The distribution was initiated in anticipation of changes in the US tax laws would adversely shake HSI’s capacity to use its FTCs. In 20X3 HSI acquired five companies at the cost of $640. The companies that were purchased are unrelated entities to the HIS parent company. The purchases were made after the management had assessed its assertion that all undistributed earnings from subsidiaries in Europe had been reinvested. The ASC 740-30 is guidance on how companies should pay deferred taxes from undistributed earnings in their subsidiaries. Hence, HSI's deferred taxes from its European subsidiaries fall under this section. Further guidance is provided in subsection 25-17. A fundamental requirement is that the parent entity should provide enough evidence that the undistributed earnings have been reinvested indefinitely and the undistributed earnings by the subsidiary will be reinvested indefinitely. Failure to provide proof will force the parent company to record deferred income taxes liability. In HSI’s case, a total of $640 million was used for the purchase of which $100 million was cash available in the US, $400 million was obtained through private placement offer, and the remaining $140 million was a distribution was European subsidiaries to the parent entity. The $140 million that was reinvested from European subsidiaries qualifies HSI for the indefinite investment exception as per ASC 740-40.
After considering the Additional Facts, do you agree with HSI’s conclusion that the indefinite investment exception under ASC 740-30 should continue to be applied to historical undistributed earnings at the end of 20X3?
The International Accounting Standards (IAS) 12.39 offers guidelines about taxation of investments on subsidiaries and associates. According to IAS, the parent entity needs to acknowledge liability on deferred taxes. The deferred tax liability is associated with temporary differences related to investment in subsidiaries, branches, and associates (Daka, n.d). However, exceptions are provided if the following conditions are met: if the parent firm can correctly time the reversal of the temporary difference. The reversal will enable the parent entity to avoid liability for the deferred taxes. The other condition that should be met to avoid liability is if it is possible to prove that a reversal of the differences will not occur in future.
In HSI’s case, the parent company required their European subsidiaries to make intercompany loans to funds the repatriation earnings to the US. Harbor Europe Holdings (HEH) which is not a separate entity from the parent company. HEH would service its loans by receiving dividends from other subsidiaries. The interest on the loan would not exceed the dividends that the company would earn from the other affiliates. Furthermore, the management was able to table evidence to prove that loan expenses would not exceed dividends earned. Again, the parent company would provide capital to cover any costs that are above the company’s earnings. Therefore, undistributed historical revenues would not be taxable in the US and that the undistributed earnings are being indefinitely reinvested.
The additional information states that earnings of subsidiaries will cover dividends to HEH. The parent company's plan to reinvest revenues to expand European operations is an explicit scheme to avoid liability on deferred taxes. Additionally, acquisition of other five companies that were unrelated to the parent company was part of the plot. It is evident that ASC 740-30 has loopholes relating to undistributed historical earnings that corporations can exploit. Internal controls need to be put in place to seal these loopholes that HSI is exploiting (Deloitte, 2017). However, under ASC 740-30, reinvestment exceptions that are applied to historical distributed earnings should not continue in HSI’s case.
References
Daka, A. (n.d.). IAS 12 income taxes. Chartered Accountants Academy. Retrieved on 19 December 2017, from https://www.icaz.org.zw/iMISDocs/ias12.pdf.
Deloitte. (2017). ASC 740- Income taxes. Deloitte Global Services Limited . Retrieved Dec 19, 2017, from Iasplus.com: https://www.iasplus.com/en-us/standards/fasb/expenses/asc740.
Proestakes, P. (2017). Income tax project. Fasb.org . Retrieved on 19 December 2017, from http://fasb.org/cs/ContentServer?c=FASBContent_C&cid=900000011152&d=&pagename=FASB%2FFASBContent_C%2FProjectUpdatePage.
