In October 2016, FASB issued Accounting Standards Update (ASU) 2016-16, Intra-Entity Transfers of Assets Other Than Inventory, amending Accounting Standards Codification (ASC) Topic 740. The new standard became effective for public businesses with fiscal years beginning after December 15, 2017, and for all other entities with fiscal years beginning after December 15, 2018. Among other objectives, the new standard seeks to simplify the reporting for intra-group transfers of assets other than inventory. One main consequence of ASU 2016-16 is that intra-group members selling assets are required to record a current tax expense or tax benefit upon asset transfers to other group members; similarly, recipients of the asset transfers are required to record a current tax expense or benefit as well as a deferred tax asset or liability. The new standard is also important for outbound transfers of assets to foreign affiliates. Overall, the new standard promises to have far-reaching effects for the financial reporting of consolidated groups, as it departs significantly from the concept of comprehensive accounting principles of the prior ASC 740.
This article reviews the changes made by ASU 2016-16 pertaining to intra-group asset transfers and provides several illustrations seeking to assist CPAs and other accounting professionals in applying the new standard for intra-group asset transfers. The article also discusses important new disclosure requirements that align ASU 2016-16 with International Financial Reporting Standards (IFRS).
Amendments to FASB Accounting Classifications
FASB issued ASU 2016-16 to improve the accounting for the income tax consequences of intra-entity transfers of tangible and intangible assets other than inventory. The idea for this project was part of FASB’s ongoing simplification initiative. This initiative was intended to identify, evaluate, and improve areas of GAAP for which cost and complexity would be reduced while maintaining or improving the usefulness of the information provided to users of financial statements. This update also substantially aligns the recognition of income tax consequences of intra-entity asset transfers with IFRS. International Accounting Standard 12, Income Taxes, which predated this ASU, requires recognition of current and deferred income taxes resulting from an intra-entity asset transfer (including a transfer involving inventory) when the transfer occurs.
Prior to the issuance of ASU 2016-16, ASC 740 was the source of authoritative GAAP recognized by FASB to be applied by nongovernmental entities. This update amended the ASC to eliminate the exception to GAAP of comprehensive recognition of current and deferred income taxes that prohibited recognizing current and deferred income tax consequences for an intra-entity asset transfer (excluding the transfer of inventory) until the asset has been sold to an outside party. Now, when a company transfers intellectual property (e.g., patents, trademarks, trade names, designs), rights to use intellectual property, or equipment between entities it controls in different tax jurisdictions, the income tax consequences of the inter-company transaction (involving assets other than inventory) must now be recognized. This requirement includes both current and deferred income tax expenses or benefits.
Intercompany transfers involving different tax jurisdictions typically have economic consequences on a consolidated basis that act as an incentive for the proposed transaction.
Implementation Guidance and Illustrations
Although it is not unusual for a company to transfer tangible and intangible property between entities within the same tax jurisdiction, the majority of such intra-entity or intercompany transfers will occur when the two entities involved are subject to different tax rates or different taxing jurisdictions. This is the case because intra-entity or intercompany transfers involving different tax jurisdictions typically have economic consequences on a consolidated basis that act as an incentive for the proposed transaction. The entity selling the asset pays income taxes when it sells the asset outside its tax group, but there is no offsetting tax benefit elsewhere in the company until the asset is sold to a third party or its value is otherwise recovered through its use in operations.
If the income tax rates are the same for the two entities involved in the intra-entity transfer, then on a consolidated basis there are no economic consequences. For example, consider the case of parent company, P, a U.S. multinational firm that sells equipment to its European subsidiary, S.
The book and tax basis of the equipment at the time of this transaction is $25,000. Assume that the sales price of the equipment to S is $30,000 and that the tax rate applicable to both entities is 30%.
For tax purposes, under the new update, P would now be required to recognize income tax expense on the profit earned on this transaction of $5,000 ($30,000 – $25,000), which would equal $1,500 (i.e., $5,000 × 0.30); the offsetting credit entry would be recorded to cash or income taxes payable. The subsidiary, S, on the other hand, would have to recognize an amount as a debit to deferred tax assets offset by a credit entry to deferred tax expense for the same $1,500. On a consolidated basis, the entries to the two balance sheet accounts (deferred tax asset and cash or income taxes payable), along with the entries to the two income statement accounts (income tax expense and deferred tax expense) would equally offset each other, resulting in a neutral economic impact on the consolidated entity’s financial statements.
Prior to ASU 2016-16, intra-entity transfers such as this hypothetical transaction had the same impact on the consolidated financial statements as an intra-entity transfer had post-ASU 2016-16 that involved two entities subject to the same tax rate. The selling entity does not record any pre-tax gain or loss; neither entity records any current or deferred income tax expense or benefit. In this example, however, the parent company would have to recognize the taxes paid in the current year’s return for the profit earned as a result of the sale (i.e., a debit to prepaid taxes and a credit to cash or income taxes payable) in the amount of $1,500.
The more common cases involving intra-entity or intercompany transactions occur when the income tax rates that apply to the two entities involved are different, which creates the economic consequences that provide the basis for the subject update. Starting with the facts above, now assume that the parent company, P, has a tax rate of 40%, while the subsidiary, S, has a tax rate of 10%.
For tax purposes, under the new update, P would recognize income tax expense on the $5,000 profit earned on this transaction equal to $2,000 (i.e., $5,000 × 0.40), while the offsetting credit entry would be recorded to cash or income taxes payable. S would recognize an amount in a deferred tax asset account, offset by a credit entry to deferred tax expense equal to $500 (i.e., $5,000 × 0.10). On a consolidated basis, the net result of the aforementioned entries is higher income tax expense by $1,500 (i.e., $2,000 income tax expense for P, reduced by the credit entry to deferred income tax expense of S by $500). Notice that if the income tax rates were reversed for the two entities, the net result on a consolidated basis would be lower income tax expense by $1,500.
If the book and tax basis of the property involved in this proposed transaction were $25,000 and it was sold for a loss to S, the signs of the entries noted in Example 2 would change. If P sold this property to S for $20,000, and P’s tax rate were 40% and S’s tax rate were 10%, this intra-entity transaction would result in a loss of $5,000 (i.e., $20,000 – $25,000).
For tax purposes, under the new update, P would record a debt to deferred taxes payable in the amount of $2,000 (i.e., $5,000 × 0.40), whereas the offsetting credit entry would be recorded to income tax expense. S, on the other hand, would record a debit entry to deferred tax expense, with an offsetting credit entry to deferred tax assets in the amount of $500 (i.e., $5,000 × 0.10). On a consolidated basis, the net result of these entries would be to reduce the amount of net income tax owed by the consolidated entity by $1,500 (i.e., the $2,000 reduction to income tax expense would be partially offset by the $500 increase in deferred tax expenses).
IRC Section 367(d) Outbound Transfers
Under existing tax law, outbound transfers of American technology to foreign affiliates come within the purview of the IRC section 367 super-royalty provisions. Under IRC section 367(d), resulting gains from technology transfers to foreign affiliates are reported under the super-royalty provisions. The super-royalty provisions generally tax gains in the future, based on an assumed royalty stream during the economic life of the technology within the purview of the IRC section 482 transfer pricing rules. Importantly, ASU 2016-16 does not address the implications for section 367(d) transactions.
ASU 2016-16 did not impose any new, additional disclosure requirements. As such, companies may have to incorporate effects arising from intragroup asset transfers in the computation of their effective tax rates. Moreover, companies may have to disclose temporary difference items giving rise to deferred tax assets or liabilities. Early adoption of ASU 2016-16 is allowed in the first accounting period for which financial statements have not been issued or have been otherwise made available. Lastly, the effects of amendments flow through retained earnings by way of cumulative adjustments in the beginning of the accounting period when the new update is adopted.
All companies were required to adopt ASU 2016-16 by December 15, 2018. The authors’ review of the actions taken by public companies as of December 2019 (as evidenced by their public filings) revealed a significant variation in the approaches used that appeared to be based on the financial characteristics of each company. For example, Newell Brands Inc., a worldwide manufacturer, marketer, and distributor of consumer and commercial products, recorded an adjustment as of January 1, 2018, that reduced retained earnings and prepaid expenses by approximately $17.8 million as a result of the adoption. Lear Corporation, an American manufacturer of automotive seating and automotive electrical systems, recognized a deferred tax asset of $2.3 million and a corresponding credit to retained earnings in conjunction with the adoption. Johnson & Johnson, a multinational manufacturer of medical devices and pharmaceutical and consumer package goods, recorded net adjustments to deferred taxes of approximately $2.0 billion, a decrease to other assets of approximately $0.7 billion and an increase to retained earnings of approximately $1.3 billion.
Smaller companies, including Shire PLC and GridIron BioNutrients, simply reported that they did not expect a material impact on their consolidated financial statements. Other even smaller companies, such as YayYo Inc. and Predictive Technology Group, reported that they are still in the process of evaluating the impact of this ASU on their financial statements. Even though some companies are still assessing the impact of ASU 2016-16 on their financial statements, it does appear FASB’s intent of improving the accounting for income tax consequences of intra-entity transfers of tangible and intangible assets other than inventory is taking effect.
Reconsidering the Impact?
The above discussion reviews the consequences of ASU 2016-16 for intra-group asset transfers. Among other consequences, the new guidance requires buyers and sellers of assets, other than inventory, to record a current tax expense or benefit along with deferred tax assets on realized gains or losses on the asset transfer. Going forward, FASB should consider amending ASU 2016-16 in view of the tax deferrals related to outbound transfers of American technologies to foreign affiliates under IRC section 367(d). In addition, to be consistent with International Accounting Standard 12, FASB should also reconsider the exception allowed under the new update for intra-group transfers involving inventory.