The new tax law introduced as the Tax Cuts and Jobs Act (TCJA) moved the U.S. federal tax system from a worldwide tax system to a territorial system. In doing so, it imposed a tax on the unrepatriated foreign earnings (deemed repatriation tax). While tax paying entities clearly have significant financial reporting implications from the enactment of the TCJA and the creation of the deemed repatriation tax, can it impact pass-through entities?
What is the Deemed Repatriation Tax?
To convert the U.S. from a worldwide tax system to a territorial system, TCJA mandates a tax on unrepatriated foreign earnings accumulated since 1986. The tax is generally applicable to at 15.5 percent on cash and cash equivalents and 8 percent for illiquid assets for controlled foreign corporations (for example: foreign subsidiaries of a U.S. corporation) and foreign corporations with a greater than 10 percent U.S. corporate ownership. The tax is measured based on either Nov. 2, 2017, or Dec. 31, 2017, whichever results in a greater tax.
Under the tax law, a special rule exists for the shareholders of an S corporation that allows the shareholder to elect to defer payment of the tax liability arising from the deemed repatriation tax until the taxable year of a triggering event, such as the sale of the interest in the foreign corporation. If the shareholder makes this election, the S corporation becomes jointly and severally liable for the tax payment and any associated penalties.
Applying U.S. GAAP
In 2009, the Financial Accounting Standards Boards (FASB) issued an accounting standards update to ASC Topic 740 Income Taxes that clarified how to assess whether an income tax was attributable to an entity or the owner of an entity. Income taxes attributable to the entity would be accounted for under ASC Topic 740 while income taxes attributable to the owner would be a transaction with the owner (i.e. dividend). Through examples it was demonstrated that a tax payment by the entity would be treated as a payment of the owner’s liability then the income tax would be attributed to the owners.
We believe that the deemed repatriation tax for an S corporation is an income tax on the owners since it is initially assessed against the owner, the owner has the opportunity to elect to defer the taxes due, and if the S corporation makes payments of the tax liability it would relieve the owners obligation. Therefore, the S corporation would not account for the deemed repatriation tax under ASC Topic 740 and would not recognize income tax expense.
If ASC Topic 740 does not apply, the S corporation must then consider when it should recognize any liability related to the payment of the tax on behalf of the owner (i.e. dividend). Several different accounting models could be considered, such as:
- Considering the payment through the general practice for dividends which would be recognized when it is "declared" by the S corporation
- Accounting for the payment by analogy as an uncertain tax liability applying the more-likely-than-not standard contained in ASC Topic 740, and thus recognizing a liability and a dividend when it is more-likely-than-not the S corporation would be making the payment
- Treating the payment as a loss contingency under ASC Topic 450 Contingencies, thus recognizing a liability and a distribution when it is probable that the S corporation would make the payment and the amount of the payment can be reasonably estimated
Although each of the above approaches has pros and cons, it is our belief that an approach based on the guidance of ASC Subtopic 405-40 Obligations Resulting from Joint and Several Liability Arrangements should be applied. ASC Subtopic 405-40 includes several scope exceptions including for Income Taxes under ASC Topic 740, however, the tax liability of the owner is not within the scope of ASC Topic 740 as discussed above and therefore the liability is not scoped out.
In addition, although the amount of the tax lability paid may change upon the future resolution of tax positions of the stockholder (such as earnings and profits from foreign subsidiaries or the reduction of the tax for foreign tax credits), we believe that changes to the amount due as a result of future events do not preclude the tax from being considered fixed based on the tax attributes existing as of the reporting date. Therefore, once the tax liability has been deferred by the stockholder the liability meets the two criteria to be in the scope of ASC Subtopic 405-40:
- Joint and several liability arrangement
- The total amount of the obligation is fixed at the reporting date
An S corporation applying the guidance of joint and several arrangements to the tax liability jointly and severally held with its owner would recognize a liability based on the amount it has agreed to pay based on its arrangement with its co-obligors (i.e. owners), plus any additional amount it expects to pay on their behalf. Applying this guidance will require significant judgment on the part of management and will likely involve discussions with the owners to determine whether the tax has been deferred and the owners' intent to pay. It may also involve updates to the measurement each reporting date that may result in periodic changes or updates to the estimate resulting in additional transactions with the owners which might be described as dividends, contributions, or some similar transaction. We do not believe the ability to indefinitely defer payment until a triggering event occurs exempts the obligation from these requirements.
Financial Statement Disclosures
As a joint and several obligation, certain disclosure requirements in ASC Subtopic 405-40 would apply, including:
- How the liability arose
- The relationship with the co-obligors
- Terms and conditions of payment
- Total amount due outstanding
- Carrying amount of liabilities and receivables related to the arrangement
- Any arrangements permitting recourse against the co-obligors
- The amount initially recognized, or the amount of change recognized in the financial statements, including where the liability and corresponding entries are presented
In addition, related party disclosures in ASC Topic 850 Related Party Disclosures may apply.
S corporations with foreign activities will need to carefully consider the amount of deemed repatriation tax that will be assess on their owners and consider the potential financial reporting ramifications of those owners deferring payment of the tax, triggering a joint and several obligation of the S corporation. Although the issue is not directly addressed in GAAP, we believe following the guidance that exists for joint and several arrangements is appropriate and provides a comprehensive approach to accounting for any obligations that arise from the deemed repatriation tax.
For More Information
If you have specific comments, questions or concerns about the financial reporting impact of these and other tax provisions, please contact Mark Winiarski of MHM's Professional Standards Group. Mark can be reached at firstname.lastname@example.org or 816.945.5614.
Published on February 06, 2018