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Accounting for Investments in Pass-through Entities

Bob Gabriel – Deloitte Tax LLP Paul Rasmussen – Deloitte Tax LLP Tax Executives Institute May 2, 2017 Houston, TX. Accounting for Investments in Pass-through Entities. Agenda. Overview Measuring deferred taxes for investments in pass-through entities Other considerations

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Accounting for Investments in Pass-through Entities

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  1. Bob Gabriel – Deloitte Tax LLPPaul Rasmussen – Deloitte Tax LLP Tax Executives Institute May 2, 2017 Houston, TX Accounting for Investments in Pass-through Entities

  2. Agenda • Overview • Measuring deferred taxes for investments in pass-through entities • Other considerations • Tax receivable agreements • Questions

  3. Pass-through entities — Overview

  4. Investments in pass-through entities Tax consequences Pass-through entities such as partnerships are generally not taxable entities • The exception would be when the partnership is a tax paying component as it relates to certain states, foreign jurisdictions, etc. • e.g., NY business tax, foreign entity tax The owners of pass-through entities are generally taxable entities and recognize deferred taxes for any financial reporting/tax basis difference in the assets that they own, including interests in pass-through entities (i.e., the outside basis difference) A pass-through entity can be owned by another pass-through entity • In that case, the current and deferred tax would be recorded by the taxable owner of the upper-tier pass-though entity An investor should generally not recognize deferred taxes on the financial reporting and tax basis differences associated with the pass-through entity’s assets and liabilities (i.e., the entity’s “inside basis differences”)

  5. Inside and outside basis differences Overview No deferred taxes are recorded in the partnership’s financial statements since tax consequences are borne by its partners If a partner is a taxable entity, deferred taxes are provided on temporary differences associated with that partner’s interest Consolidated F/S Deferred tax on temporary difference associated with the partnership investment C Corp Investor 60% 40% No deferred tax recorded in the partnership’s financial statements P-ship P-Ship

  6. Measuring deferred taxes for investments in pass‐through entities

  7. Accounting treatment of partnership interest Overview Defining the relevant temporary difference(s) • Deferred taxes are recorded on the difference between the financial statement amount of the investment in the partnership and its tax basis (i.e., the outside basis difference) Approaches for recording deferred taxes on outside basis differences • Approach 1: “Look-through” method • Apply the exceptions to the comprehensive model of recognition of deferred taxes (ASC 740-10-25-3) to the relevant portion of the outside basis difference • Approach 2: “Outside basis” method • Do not apply the exceptions and record deferred taxes on the entire outside basis difference Application of the two approaches will not necessarily result in an equal amount of deferred taxes being recognized • Note: Consultation with your attest firm is recommended

  8. Accounting treatment of partnership interest Financial reporting and tax basis Financial reporting basis in a partnership • The financial reporting basis of a partner’s investment in a partnership is generally determined by the historical cost of the investment and the applicable method of accounting (e.g., cost method, equity method, fair value option) • For a consolidated entity, financial reporting basis will generally equal consolidated net assets less non-controlling interest in such consolidated net assets • In certain circumstances financial reporting basis will equal the financial reporting basis of the net assets contributed (common control transactions, joint venture formations, etc.) • The financial reporting basis in the partnership can also be thought of as the sales price that would cause no book gain or loss Relevant tax basis in a partnership • The tax basis of a partner’s investment in a partnership is the amount that would be compared to proceeds received to determine gain or loss on sale as defined by the relevant tax code • Note: The partner’s share of partnership liabilities is not considered part of the tax basis for purposes of determining the outside basis difference

  9. Outside basis approach vs. look-through approach Example 1 — Consolidated financial statements Outside basis approach • DTL = $264([$3,000 ‒ $2,340] x 40% tax rate) Look-through approach • DTL = $144([$3,000 – [A]300‒ $2,340] x 40% tax rate) P (40%) NCI 40% 60% GAAP Basis 3,000 Tax Basis 2,340 PP&E 4,500 Goodwill 500 P-ship Note: This example assumes inside and outside tax basis are the same and there are no special partnership allocations; additional complexities arise when this is not the case

  10. Look-through – Additional complexities Example 2 – Base Facts • A forms a partnership (P) by contributing intellectual property (IP) that it recently acquired in a non-taxable acquisition, with a fair value of $1,000, financial reporting basis of $1,000 and tax basis of $0 • Shortly after A forms P, Non-controlling Interest (NCI) contributes $1,000 cash for an interest in P • A maintains control of P • A plans on operating P for the foreseeable future A NCI IP Cash P

  11. Look-through – Additional complexities Example 2 – IRC §704 (c) traditional allocation methodology Impact of A’s contribution of Intellectual Property Impact of NCI’s contribution of cash* * Traditional partnership allocation method pursuant to IRC § 704(c) results in NCI not being allocated any amortization expense associated with the IP as there is no tax basis in the IP

  12. Look-through – Additional complexities Example 2 – IRC §704 (c) traditional allocation methodology (cont’d) Observations [1] Taxable as IP is recovered (i.e., over the life of the asset) [2] Taxable when P is sold or liquidated in a taxable liquidation [3] Total of inside basis differences does not equal the outside basis difference Question • What would A’s taxable income be if it recovered its investment at the financial reporting carrying amount of $1,000?

  13. Look-through – Additional complexities Example 2 – IRC §704 (c) remedial allocation methodology Impact of A’s contribution of Intellectual property Impact of NCI’s contribution of cash* * Remedial partnership allocation method pursuant to IRC § 704(c) results in NCI being allocated $500 of amortization expense associated with the IP with A recognizing $500 of income to accommodate

  14. Look-through – Additional complexities Example 2 – IRC §704 (c) remedial allocation methodology (cont’d) Observations [1] Taxable as IP is recovered (i.e., over the life of the asset) [2] Taxable when P is sold or liquidated in a taxable liquidation [3] Total of inside basis differences does equal the outside basis difference Question • What would A’s taxable income be if it recovered its investment at the financial reporting carrying amount of $1,000?

  15. Look-through – Additional complexities Example 3 – Base Facts • A forms a partnership (P) by contributing non-IP assets that it recently acquired in a taxable acquisition, with a fair value of $1,000, financial reporting basis of $1,000 and tax basis of $1,000 • Shortly after A forms P, NCI contributes IP with a fair value of $1,000 and tax basis of $0 • A maintains control of P • A plans on operating P for the foreseeable future A NCI non-IP IP P

  16. Look-through – Additional complexities Example 3 – IRC §704 (c) traditional allocation methodology Impact of A’s contribution of Assets Impact of NCI’s contribution of IP* * Traditional partnership allocation method pursuant to IRC § 704(c) results in A not being allocated any amortization expense associated with the respect to the NCI IP

  17. Look-through – Additional complexities Example 3 — IRC §704 (c) traditional allocation methodology (cont’d) Observations [1] Taxable as IP is recovered (i.e., over the life of the asset) [2] Deductible when P is sold or liquidated in a taxable liquidation* [3] Total of inside basis differences ≠ the outside basis difference Question • What would A’s taxable income be if it recovered its investment at the financial reporting carrying amount of $1,000? * Consider application of ASC 740-30-25-9 which provides an exception to recording the DTA on tax over financial reporting basis in a subsidiary when it is not apparent that the temporary difference will reverse in the foreseeable future

  18. Look-through – Additional complexities Example 3 – IRC §704 (c) remedial allocation methodology Impact of A’s contribution of IP Impact of NCI’s contribution of IP* * Remedialallocation method pursuant to IRC § 704(c) results in A being allocated amortization expense with the respect to the NCI IP with NCI recognizing $500 of income to accommodate

  19. Look-through – Additional complexities Example 3 – IRC §704 (c) remedial allocation methodology (cont’d) Observations [1] Taxable as IP is recovered (i.e., over the life of the asset) [2] Deductible when P is sold or liquidated in a taxable liquidation [3] Total of inside basis differences = the outside basis difference Question • What would A’s taxable income be if it recovered its investment at the financial reporting carrying amount of $1,000?

  20. Measuring deferred taxes Applicability of ASC 740-30-25-9 to partnership investments The exception may not apply if the components of the temporary difference causing the tax over financial reporting outside basis difference reverse in the normal course of partnership’s operations (i.e., foreseeable future) • However, there may be circumstances where a temporary difference only reverses upon a future sale or liquidation and the exception should be considered • Note: Consultation with your attest firm is recommended

  21. Application of exceptions Other exceptions to the requirements for recognition of deferred taxes No DTL recognition for an excess of the amount for financial reporting over the tax basis of an investment in a foreign subsidiary unless apparent that the temporary difference will reverse in the foreseeable future (ASC 740-10-25-3(a)) A prohibition on recognition of a DTL related to a greater-than-50%-owned domestic entity for which a basis difference can be recovered tax free and the parent expects it will use that means (ASC 740-30-25-7) • Note:These exceptions would generally not be applicable where the outside basis approach is utilized to measure deferred taxes attributable to the partnership but may be of relevance under the look-through approach

  22. Consolidated pass-through entity Example 4 Assumptions • A company drops a subsidiary with a higher tax basis than financial reporting basis into a partnership, which it will control through its 60% ownership and hence consolidate for financial reporting purposes • The NCI contributes assets to the partnership for the remaining 40% interest • P uses the outside basis approach for measuring deferred taxes on its investment in the partnership interest • P has established a DTA for the higher tax basis in the partnership interest

  23. Consolidated pass-through entity Example 4 (cont’d) Question • Is recording a DTA upon contribution of the subsidiary to the partnership appropriate? Consolidated F/S After Before P P NCI 100% Consolidated F/S 60% 40% S P-ship P-Ship 100% Includes assets from NCI S

  24. Consolidated pass-through entity Example 4 (cont’d) Answer • The corporation that was dropped into the partnership was a subsidiary and was subject to ASC 740-30-25-9; no DTA was permitted • After dropping the corporation into the partnership, the “subsidiary” relationship to the “parent” continues as the partnership would be consolidated and any subsidiary of the partnership will be reported as a subsidiary of the parent • One view is that ASC 740-30-25-9 should be continued so long as corporation and its former parent continue to have a parent/subsidiary relationship • If the ASC 740-30-25-9 prohibition was continued, the financial reporting and tax basis in the partnership would be bifurcated between that part attributable to the partnership’s basis in the corporation (no DTA) and that part attributable to its other assets (normal deferred tax accounting) • Note: Consultation with your attest firm is recommended

  25. Pass-through entities - other considerations

  26. ETR consequences

  27. ETR consequences of non-controlling interests Overview The financial statement amounts reported for income tax expense and net income attributable to non-controlling interest differ based on whether the subsidiary is a C‐corporation or a partnership • C-corporation: A C-corporation is generally a taxpayer • Therefore, a parent that consolidates a C-corporation would include 100% of the income tax expense attributable to the C-corporation’s pre-tax income • Partnership: Income taxes related to income of a partnership is generally not the obligation of the partnership itself • Instead, the partners are responsible for income taxes on their share of the partnership’s income • Therefore, a parent that consolidates a partnership would consolidate 100% of the partnership pre-tax income, but only include income taxes on its share of the partnership’s income in the consolidated income tax provision (results in a reconciling item in the parent’s income tax rate reconciliation)

  28. ETR consequences of non-controlling interests Example Assumptions • Parent (P), a US corporation consolidates Subsidiary (S), a domestic partnership with a 20% noncontrolling interest (NCI) • S is not subject to income taxes in any jurisdiction in which it operates • S earns $1,000 in 20X0 • Assume a federal statutory income tax rate of 35% Question • Compare the effective tax rates of S as a partnership and S as a corporation

  29. ETR consequences of non-controlling interests Showing corporate subsidiary for contrast Example — Solution [a] = ($1,000 x 80% x 35%) ($1,000 x 35%) [b] = ($1,000 x 20%) ($650 x 20%)

  30. Pass-through entities - tax receivable agreements

  31. Accounting for deferred tax assets related to tax receivable agreements In recent years, founders of certain closely held partnerships have created publicly traded corporations (Pubcos) to provide liquidity for their founders. • Pubco generally acquires a controlling interest in the partnership which results in the following: • For income tax purposes, the underlying assets represented by Pubco’s interest in the partnership are stepped up to FMV via a Section 754 election • For financial reporting purposes, the assets are consolidated at their historical cost due to the rules regarding transactions among entities under common control • Tax greater than book basis results in the recognition of a DTA • Founders benefit from Pubco’s tax savings from the tax basis step-up by entering into a tax-receivable agreement (TRA), wherein, the TRA provides for the future tax savings to be split between the founders and Pubco. • When paid, the TRA liability is considered additional consideration and provides an additional asset basis increase for tax purposes • Results in the recognition of an additional DTA which requires an algebraic computation

  32. Accounting for deferred tax assets related to tax receivable agreements (cont.) Founders own 100% of Partnership. Founders form Pubco, which raises $1,000 through an IPO and purchases 40% of the Partnership interest from Founders for $1,000. Founders control Pubco through a special class of stock. Founders’ tax basis in the 40% interest sold to Pubco is $100. Partnership makes an IRC §754 election to receive a tax basis step-up. Facts • ADDITIONAL FACTS: • Founders and Pubco have a TRA, pursuant to which Pubco will pay Founders 90% of any cash tax savings associated with the step-up in tax basis (assume all goodwill) • Assume a 40% statutory tax rate

  33. Accounting for deferred tax assets related to tax receivable agreements (cont.) Public Founders TRA = $506.25 Pubco 40% 60% DTA = $562.50 P-ship *TRA liability: [(900x40%)/(1-(90%x40%)] = $562.5 x 90% = $506.25

  34. Speaker Bios Paul Rasmussen Tax Senior ManagerDeloitte Tax LLPHouston, TX Phone +1 713 982 4347Email: paurasmussen@deloitte.com Bob Gabriel Tax PartnerDeloitte Tax LLPHouston, TX Phone +1 713 982 4826Email: rgabriel@deloitte.com Relevant Experience Paul has more than 10 years of experience in public accounting. His time has been dedicated to providing tax provision and compliance services for energy related businesses.  He has served companies within both public and private sectors and has experience with corporate and partnership tax structures. He is a specialist with respect to income tax accounting issues including global tax provision processes, tax basis balance sheet testing, purchase accounting, and deficiency remediation.  Paul works on a number of tax provision preparation and attest engagements covering financial reporting under both US GAAP and IFRS. Paul is a regular speaker at Tax Executive Institute and regular instructor at Deloitte ASC 740 national training. Education Paul received a Bachelor of Science degree in Accounting and a Masters degree in Accounting from Brigham Young University. Relevant Experience Bob is a Tax Partner in the Business Tax Services practice and has more than 15 years of experience in public accounting providing services to public and private clients in a variety of industries including integrated energy, oilfield service, engineering and construction, and manufacturing and distribution. Bob specializes in accounting for income taxes and assists clients with tax process and systems improvements and global tax provision issues including tax basis balance sheet analysis, currency issues, and uncertain tax positions. Bob has been an instructor and speaker at internal and external tax training sessions relating to income tax accounting issues including the Tax Executive Institute and Deloitte’s Financial Reporting of Taxes Dbrief Series for Tax Executives. Education Bob received a Bachelor of Business Administration degree and a Masters in Professional Accounting from the University of Texas at Austin.

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