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Preparing carve-out
tax provisions
Considerations under
current tax law
A PwC Deals publication

April 2018
Introduction The SEC staff issued Staff Accounting Bulletin No. 118 (SAB
118) to address the application of US GAAP in situations
when a registrant does not have the necessary information
Businesses that prepare consolidated or group financial available, prepared, or analyzed (including computations)
statements often also have to prepare separate financial in reasonable detail to complete the accounting for certain
statements for one or more divisions, business units, and/ income tax effects of the 2017 Act. SAB 118 provides three
or subsidiaries. These kinds of financial statements, often categories for the status of the accounting for the impact of
referred to as “carve-out” financial statements, are frequently the 2017 Act in the period of enactment: 1) measurement of
needed as part of a pending transaction such as an initial certain income tax effects is complete, 2) measurement of
public offering, spin off, or corporate divestiture. In other certain income tax effects can be reasonably estimated and
instances, they may be required for certain statutory or 3) measurement of certain tax effects cannot be reasonably
regulatory filings on an ongoing periodic basis, which is also estimated. SAB 118 provides that the measurement period
common outside of the United States. is complete when the company’s accounting is complete but
Preparing carve-out financial statements can be complicated in no circumstances should the measurement period extend
and often highly subjective. Accounting rules and guidance beyond one year of the enactment date. As discussed below,
governing the composition of the carve-out entity and the hindsight should not be used when preparing a carve-out tax
resulting application of US generally accepted accounting provision, which will be complicated by the fact that further
principles is limited. What is clear is that carve-out financial interpretive guidance is expected from the Internal Revenue
statements for taxable entities must comply with Accounting Service and Treasury.
Standards Codification (ASC) 740, Income Taxes.
2. Understand the purpose for the carve-out
Similarly, preparing tax provisions for carve-out financial
statements can be challenging, particularly if separate
financial statements and the corresponding
financial statements (including a tax provision) have not pre-tax accounting
been prepared historically. Typically, preparers must decide Carve-out financial statements are often guided by the legal
between preparing SEC-compliant financial statements or or strategic form of a business transaction that involves
abbreviated financial statements that include direct revenues, capital formation or the acquisition or disposal of a portion
expenses, and assets and liabilities. Both present unique of a larger entity. The statements also may be guided by
considerations for preparers. Public companies are required regulatory requirements for certain industry-specific filings.
to obtain permission from the Securities and Exchange Understanding the overall context and intended use of the
Commission (SEC) to use abbreviated financial statements. statements is important in deciding which tax provision
allocation method to apply and in aligning the application of
This publication, while not all inclusive, explains ten key
the chosen allocation method to the pre-tax accounts.
principles that will help enable preparers to manage a carve-
out tax provision process with more ease. Tax provision preparers need to coordinate closely with those
responsible for the pre-tax aspects of carve-out financial
1. US tax reform statements because tax provisions are supposed to be based
On December 22, 2017, President Trump signed tax reform on the financial statement accounts that represent the
legislation (the 2017 Act), which includes a broad range of operations of the carve-out entity.
tax provisions affecting business, including corporate tax Accordingly, it’s imperative to fully understand the pre-tax
rates, business deductions, and international provisions. accounts that will be included in the carve-out statements,
The 2017 Act has pervasive financial reporting implications. as well as the impacts of any adjustments to the accounts, to
The passage of the 2017 Act will create additional complexity reflect the appropriate income tax effect.
and judgments in preparing the carve-out tax provision. Tax provisions can be affected by the use of accounting
Many of the new tax laws require calculations to be policies or methodologies that differ from those of the
completed at the consolidated tax return level, which will consolidated entity — for example, cost allocations. Carve-
create challenges when applying the preferred carve-out tax out financial statements should reflect all the costs of doing
provision method, the separate return method, or other tax business. That typically requires an allocation of corporate
allocations methods. overhead expenses (and the related tax effects) to the carve-

The Passage of the 2017 Act will create additional complexities and
judgments in preparing carve-out tax provisions.

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Lastly, preparers of carve-out financial statements may need
to evaluate their current systems and processes that are in
Generally, carve-outs will require place to calculate the carve-out tax provision. Generally,
carve-outs will require data and calculations at a more
data and calculations at a more granular level, as historical tax processes and systems were
granular level, as historical tax pro- designed when the carve-out entity was part of a larger
group. Preparers should assess areas of the carve-out
cesses and systems were designed provision where the completeness and accuracy of financial
when the carve-out entity was part statement assertions need to be reassessed for the carve-out
tax provision.
of a larger group.
3. The separate return method is the SEC’s
preferred method
out entity — even if allocations were not previously made. ASC 740-10-30-27 requires that the current and deferred
When multiple jurisdictions are included within the carve- tax expense for a group that files a consolidated return be
out financial statements, costs may need to be allocated allocated among the group members when those members
to legal entities or jurisdictions so preparers can assess the issue separate financial statements. While ASC 740 does not
appropriateness of the tax rate applied to these costs. require the use of any particular allocation method, it does
Stand-alone financials may also reflect pushdown accounting require the method to be systematic, rational, and consistent
adjustments, if pushdown accounting has been elected. with the broad principles of ASC 740. It goes on to indicate
The authoritative literature provides a general principle but that the separate return method meets those criteria. In
does not provide guidance for recognizing and measuring addition, the SEC staff has stated that it believes the separate
specific items in a company’s separate financial statements return method is the preferred method.
when pushdown accounting is elected. As such, items such as Under the separate return method, the carve-out entity
contingent consideration, indemnifications, and transaction calculates its tax provision as if it were filing its own
costs should be assessed for pushdown depending on the separate tax return based on the pre-tax accounts included
specific facts and circumstances, and the tax provision in the carve-out entity.1 This can result in perceived
process should ensure any pushdown accounting adjustments inconsistencies between the tax provision of the carve-out
are assessed. entity and the tax provision of the consolidated group. This
In addition, if pushdown accounting has not been elected, but is acceptable, as ASC 740 acknowledges that if the separate
the carve-out financial statements include legal entities that return method is used, the sum of the amounts allocated
were accounted for as a purchase of assets for tax purposes to individual members of the group may not equal the
when originally acquired in the past, there is most likely a consolidated amount.
change in the tax bases of the assets and liabilities of the For example, it’s possible that the carve-out entity
carve-out without a corresponding change in the book bases could recognize a deferred tax asset for a loss or credit
of the carve-out. In this situation, deferred taxes would be carryforward, even if there is no carryforward on a
recognized in the carve-out’s financial statements for the consolidated basis (e.g., the attribute was used in a
book-to-tax basis differences that result consolidated tax return). In other cases, the carve-out entity
Intercompany transactions that were formerly eliminated could reflect a current-year loss as being carried back against
in the consolidated financial statements (for example, its taxable income in the carryback period, even though the
transactions between the carve-out entity and other entities consolidated group was in a loss carryforward position. In
in the consolidated financial statements) generally would another common scenario, a valuation allowance might be
not be eliminated in the carve-out financial statements. necessary for the carve-out entity (because it cannot rely on
For example, sales of inventory to a sister company that the taxable income of the group), even though no valuation
are eliminated in the consolidated financial statements allowance is needed for the consolidated group. This might
would remain in the carve-out statements, often as related- be the case if the carve-out entity has been generating
party items. losses while the other members of the group are profitable.
Alternatively, the converse may be true: A profitable carve-
Similarly, it may be appropriate for carve-out statements to out entity may require a tax provision, even though the
reflect intercompany transaction gains (or losses) that were remaining members of the group are generating losses.
previously deferred in a consolidated tax return. It would
be necessary to assess whether the respective income tax
accounting effects are recognized in equity, in accordance 1 If the carve-out entity includes multiple subsidiaries that would
with ASC 740-20-45-11(c) or (g). qualify as a consolidated (or unitary) tax group, it would be
appropriate to calculate the tax provision as if the carve-out
entity were filing a consolidated (or unitary) tax return for
such group.

Preparing carve-out tax provisions: Considerations under current tax law 3


foreign earnings in the carve-out financial statements.
Nor, as explained later, would it be appropriate to reassess
the recognition and measurement conclusions related to
uncertain tax positions on a stand-alone basis. Elections
made in a consolidated tax return generally should also be
followed in the carve-out tax provision. If it’s expected that
assertions or tax elections for the carve-out entity may change
in the near future (e.g., after it has been separated from the
consolidated group), it may be appropriate to disclose such
expectations and the estimated financial reporting impact of
such a change.
The historical legal entity structure generally should not
be recast for purposes of the carve-out tax provision. For
example, if the carve-out entity includes either newly created
As a result, a valuation allowance may not be needed for corporations (heretofore corporate divisions or business
the carve-out entity, even though a valuation allowance is units) or businesses whose stock is not owned directly by an
required for the consolidated group. entity in the carve-out group, the historic legal entities would
be considered as remaining intact for purposes of the carve-
While the carve-out may represent an entire division, it out tax provision.
seldom conforms to the legal entity tax accounting that is
generally used for the preparation of the tax returns.
4. Other methods may be acceptable
Since the separate return method requires the carve-out Although the separate return method is the preferred
entity to prepare its tax provision as if it were filing its method, ASC 740 does not require its use.2 Another method
own separate tax return, it may be appropriate to consider may be acceptable as long as it’s systematic, rational, and
whether calculations performed for the consolidated consistent with the broad principles of ASC 740.3 One such
financial statements should be adjusted. For example, the method is the separate company as modified for benefits-for-
state tax apportionment factors, filing methodologies and loss approach.
state tax attributes may be different for the carve-out entity
than for the consolidated group. In addition, items such The benefits-for-loss approach modifies the separate return
as research and foreign tax credits may also be calculated method so that net operating losses or other tax attributes are
differently for the carve-out entity than for the consolidated characterized as realized by the carve-out entity when those
group. Further, the application of the separate return tax attributes are used in a consolidated tax return. This is the
method may result in changes in timing of when a carve-out case even if the subsidiary would not otherwise have realized
entity monetizes tax attributes recognized in the financial those tax attributes on a stand- alone basis. Thus when the
statements, which would impact previously reported cash benefit of a tax attribute is recognized in the consolidated
flows from operations. financial statements, the subsidiary would reflect a benefit
in its separate financial statements. This may not be the
Although the carve-out balance sheet will drive the initial case, however, if the consolidated group requires a valuation
assessment of deferred taxes for the carve-out, deferred tax allowance on its deferred tax assets.
balances not associated with a single underlying pre-tax
account (e.g., uniform capitalization costs) must be allocated
utilizing a reasonable method (e.g., a method consistent with 2 A change in tax allocation method is considered a change in
the principles of ASC 740 to allocate previously calculated accounting principle. Therefore, a change from the preferred
balances or an approach where a new deferred is computed method (i.e., the separate return method) to another method
based on the pretax balances included in the carve-out would not be appropriate. Companies should consider whether
financial statements). they have previously adopted a tax allocation method for other
subsidiaries or carve-out entities. Generally, the same allocation
The separate return method is, however, nonetheless an method should be applied to all members of the consolidated
allocation of the group tax provision. Accordingly, certain reporting group. However, there may be instances, depending
aspects of the historical income tax accounting for the on the facts and circumstances, in which it is acceptable to apply
consolidated entity should not be changed in carve- out different tax allocation methods to different members of the
financial statements. In general, it’s not appropriate to group.
revisit historical assertions management has made of the 3 ASC 740 specifies that methods not consistent with its principles
consolidated group on the basis that the assertions would include methods that a) allocate only current taxes payable to
a member of a group that has taxable temporary differences,
have been different if made by the stand-alone entity.
b) allocate deferred taxes using a method that is fundamentally
For example, it wouldn’t be appropriate to use a different different than the asset and liability method prescribed by ASC
assertion for the indefinite reinvestment of undistributed 740, or c) allocate no current or deferred tax expense to a member
of the group that has taxable income because the consolidated
group has no current or deferred tax expense.

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Companies may need to prepare separate tax provision calculations for each
material jurisdiction in which the carve-out operations take place.

The benefits-for-loss approach may eliminate some of the received under the tax sharing agreement and the expected
perceived inconsistencies that would arise from applying the settlement amount based on the application of ASC 740 is
separate return method. One example of this would be if the treated as a dividend or capital contribution and should be
carve-out entity generated a taxable loss on a stand-alone recorded in equity.
basis. The loss was historically included in the consolidated
tax return of the consolidated entity. The taxable loss offset 6. Nexus considerations
taxable income of other divisions in the consolidated tax Inevitably, the carve-out will have a different state, local, and
return, reducing the overall tax liability of the consolidated foreign tax profile. Companies may need to prepare separate
entity. Under the benefits-for-loss approach, the carve-out tax provision calculations for each material jurisdiction in
entity would record a tax benefit for the utilization of its loss which the carve-out operations take place. Considerations
in the consolidated tax return, as the loss has been realized may include, but are not limited to, the following:
by the overall consolidated entity. Under the separate return
method, the carve-out entity would record a similar tax • Identifications and use of tax attributes.
benefit as done under the benefits-for-loss approach, but • Recalculation/allocation of previously recorded outside
would also have to assess whether that benefit was realizable basis deferred tax liabilities.
as part of the stand-alone carve-out entity’s valuation • The ability to offset repatriation liabilities with foreign
allowance assessment. tax credits.
Companies should carefully evaluate the specific facts and • The impact of intercompany transactions.
circumstances before deciding that another method is • Recalculated state and local apportionment for the
appropriate — for example, the existence of a tax sharing carve-out.
agreement. • Assessment of separate/unitary filing methodologies.
Depending upon the overall circumstances, the use of
another method may be appropriate if it provides more 7. Uncertain tax positions in carve-out
useful information to the users of the carve-out financial financial statements
statements. Accounting for uncertain tax positions is codified within ASC
However, if carve-out financial statements will be included in 740. Accordingly, entities need to apply those accounting
an initial public offering with the SEC using a method other principles for uncertain tax positions in the carve-out
than the separate return method (for example, the benefits- financial statements.
for- loss approach), a pro forma income statement for the When applying ASC 740’s recognition and measurement
most recent year and interim period reflecting a tax provision criteria, it’s inappropriate for the carve-out entity to change
calculated using the separate return method may be required. the assumptions used historically to assess the recognition
and measurement of its uncertain tax positions. The
5. Reflect the differences between the tax preparation of carve-out financial statements, in and of
allocation method and any tax sharing itself, doesn’t constitute new information that would justify
recording a change with respect to uncertain tax positions.4
agreements in equity
Therefore, management should not change the historical
Companies that file consolidated tax returns often have tax amounts of liabilities (or other unrecognized tax benefits)
sharing agreements that govern the intercompany settlement related to uncertain tax positions when preparing carve-out
of tax obligations. Although a tax sharing agreement could be financial statements — even if they believe they would have
a factor in determining what method the company will use to applied different assumptions for the carve-out entity on a
allocate its tax provision, the tax sharing agreement does not stand-alone basis.
dictate the choice of a tax provision allocation policy. In fact,
it may be inappropriate to allocate an income tax provision
based on a tax sharing agreement because the agreement
may not satisfy the requirements of ASC 740. If a tax sharing 4 ASC 740 indicates that changes in judgment regarding
recognition and measurement should result from the evaluation
agreement differs from the chosen method of tax allocation
of new information and not from a new evaluation or new
under ASC 740, the difference between the amount paid or
interpretation of information that was available in a previous
period.

Preparing carve-out tax provisions: Considerations under current tax law 5


8. The use of hindsight is prohibited 10. Transparent disclosures should be provided
ASC 740 states that hindsight should not be used when Choosing an appropriate tax provision allocation method
restating interim or annual periods. This guidance also requires careful judgment. Accordingly, disclosures regarding
applies to the preparation of carve-out financial statements. the chosen policy should be sufficiently transparent to enable
The assertions or measurements used for each period financial statement users to make informed decisions.
presented should be prepared using the same evidence
ASC 740 requires an entity that is a part of a group that files
that existed at that time.
a consolidated tax return to disclose the following in its
Multi-year carve-out statements are often prepared separate financial statements:
simultaneously. However, it may not be appropriate to use
• The aggregate amount of current and deferred tax
the same assertions for each year presented. For example,
expense for each statement of earnings presented and
let’s consider a company that’s preparing carve-out financial
the amount of any tax-related balances due to or from
statements for multiple periods. In the earliest period, a
affiliates as of the date of each statement of financial
deferred tax asset was supportable based on the evidence
position presented
available at that time. However, in a subsequent period
the economic environment declined, leading to significant • The principal provisions of the method by which the
losses and a conclusion that the deferred tax asset is no consolidated amount of current and deferred tax
longer supportable. In this case, it would not be appropriate expense is allocated to members of the group, and the
to use hindsight and record a valuation allowance in the nature and effect of any changes in that method (and
earliest period. in determining related balances to or from affiliates)
during the years for which disclosures are presented
9. The issue of materiality
Although these disclosure requirements are in lieu of, rather
Preparation of the carve-out provision will necessitate than in addition to, the general disclosure requirements of
a fresh look at materiality, as the materiality threshold ASC 740, it’s generally advisable to include a description
for the carve-out entity will be different than that for the of the kinds (and potentially the amounts) of significant
consolidate parent. Similar to pre-tax accounting, the change temporary differences. Additionally, if the carve-out financial
in materiality could cause items previously considered statements will be filed with the SEC, the disclosures should
immaterial from a consolidated parent perspective to become be as comprehensive as if the carve-out entity were a separate
material for the carve-out entity. An early assessment of taxpayer.
materiality considerations will help aid in the completeness
of a robust analysis in a timely fashion that takes into account Similarly, disclosures regarding uncertain tax positions for
the updated materiality thresholds for both pre-tax and tax the carve-out entity would be appropriate. However, the
considerations. level of uncertain-tax-position-related disclosures may vary
depending on the tax allocation method chosen, as well as
the other ASC 740 disclosures provided. It’s also appropriate
to disclose any tax attributes that have been allocated to the
carve-out entity that will not remain with it upon separation
Preparation of the carve-out pro- from the consolidated group. For example, there may be a
separate return method deferred tax asset for a loss or credit
vision will necessitate a fresh look carryforward that was used in a consolidated tax return. Any
at materiality, as the materiality such carryforwards or other attributes should be identified
with appropriate disclosures to enable the carve-out financial
threshold for the carve-out entity statement users to make informed decisions.
will be different than that for the
consolidate parent.

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Getting good advice Conclusion
Carve-out transactions are highly complex. Time and time Preparing income tax provisions for carve-out financial
again, our clients tell us that preparing carve-out financial statements can be complicated. The selection of an
statements, including the carve-out tax provision, often appropriate tax allocation method requires significant
prolongs the entire divestiture transaction. First and judgment; many issues can arise when applying the chosen
foremost, preparers of carve-out financial statements for allocation method. By taking the key principles discussed in
taxable entities must stay current on the changing tax laws this paper into account, preparers will be able to establish a
and be sure to comply with ASC 740, Income Taxes. solid foundation for building reliable tax provisions for the
carve-out entity.
Savvy companies proactively assess the financial reporting
and accounting implications related to carve-outs and
supplement existing financial, accounting, and audit
resources with deal team members who deliver independent
advice on mergers, acquisitions and capital markets
transactions.

Preparing carve-out tax provisions: Considerations under current tax law 7


How PwC Can help
Harnessing your company’s potential and choosing the right path requires foresight that only comes from a deep fluency in
strategy, investment banking and deals, from start to finish. Whether you’re looking to find new opportunities today or secure
your future place, PwC can help.
We work with you at any point in your journey, using the latest technology and data analytics tools, to deliver the objective
insights you need to help make the right decision at the right time. With holistic advice that considers your entire business,
PwC can help you set your sights high and execute the roadmap to get you where you want to be.
For a deeper discussion on deal considerations, including divestiture tax preparation and corporate exit strategies please
contact the partners below or your local PwC partner.

Contact us
Michael Niland
US Divestitures Services Leader
+1 678 419 3586
michael.p.niland@pwc.com
Connect on LinkedIn

Rick Levin
US Tax Accounting Services Leader
312 298 3539
richard.c.levin@pwc.com
Connect on LinkedIn

Trevor Wade
US Tax Partner
+1 717 877 2903
james.wade@pwc.com
Connect on LinkedIn

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© 2018 PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates,and may sometimes refer to the PwC net-
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