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Income Tax Changes Coming for Select Intra-Entity Asset Transfers

Nov. 15, 2016

Companies that exchange assets other than inventory between related parties will be facing changes to the timing of the recognition of the income tax effect of the transfer.

On October 24, 2016, the Financial Accounting Standards Board (FASB) released an accounting standards update that will require entities to recognize the income tax consequences for a non-inventory asset transfer on the date the transfer occurs. Accounting Standards Update 2016-16, Accounting for Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory will take effect for public business entities in annual periods, including interim periods within those annual periods, beginning after December 15, 2017 (i.e., 2018 calendar year). Non-public entities will adopt for annual periods beginning after December 15, 2018 (i.e., 2019 calendar year) and interim periods beginning after December 15, 2019 (i.e., 2020 calendar year).

Reason for the Change

The FASB released the accounting standards update as part of the Board's Simplification Initiative to reduce complexity in accounting standards. The new guidance aims to increase transparency by requiring a reporting entity to account for the economic consequences of an intra-entity asset transfer, other than inventory, in the same period the asset is transferred, more closely aligning the recognition of income taxes with tax-related cash flows. The new guidance should also reduce diversity in practice and more closely align U.S. Generally Accepted Accounting Principles (U.S. GAAP) with IFRS.

Under current U.S. GAAP, the tax effects of an intra-entity asset transfer are deferred until the transferred asset is sold to a third party or otherwise recovered through use. The new guidance eliminates this delayed recognition of current and deferred income taxes on all intra-entity sales of assets other than inventory. As a result, an entity would recognize both the tax expense from the sale of assets and any deferred tax assets that arise in the buyer's jurisdiction when the transfer occurs, even though the pre-tax effects of the transaction are eliminated in consolidation. The new guidance does not apply to intra-entity transfers of inventory. As a result, any income tax consequences resulting from the intra-entity sale of inventory will continue to be deferred until the inventory is sold to a third party.

Inventory is the type of asset that is most commonly sold between related party entities. The cost and complexity of changing the income tax recognition for inventory coupled with the nature of how quickly inventory typically turns, likely resulted in the scoping out of inventory out of the recent accounting standards update.

Impact on Reporting Entities

The new guidance will likely have an effect on a reporting entities' worldwide effective tax rate. Consider a company that transfers property to a related entity in a jurisdiction with a lower tax rate. The seller will recognize current tax expense for the gain on sale that will be partially offset by a deferred tax benefit in the buyer's jurisdiction for the tax-over-book basis difference in the transferred property. Because the intercompany transaction has no impact on consolidated pre-tax book income, the recognition of additional tax expense will result in an increase to the overall effective tax rate.

Companies that frequently engage in non-inventory intra-entity asset transfers will likely see an impact on their net income and earnings-per-share when the transfer occurs, rather than at a future date.

What's Next?

Adopting the income tax recognition standards requires a modified retrospective approach to transition to the new guidance, with a cumulative-effective adjustment applied to retained earnings as of the beginning of the adoption period.

There will be no additional disclosure requirements under the standard. However, in the first reporting period of adoption, the reporting entities should disclose the nature of and reason for the change in accounting principle, the cumulative effect of the change on retained earnings and the effect of the new guidance on continuing operations, net income or other affected financial statement line items for the period. Entities will likely disclose a comparison of income tax benefits with statutory expectations, such as a rate of reconciliation for public entities or a description of the nature of each significant reconciling item for nonpublic entities.

Early adoption is available, but it must be done in the beginning of an annual reporting period or interim period for which a financial statement has not been made available. Calendar year public companies looking to early adopt would be required to adopt in the first quarter of 2017.

If you have any specific comments, questions or concerns about how the changes to income tax recognition would affect you, please contact us.

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