Advanced Accounting 74-B Taxation of Consolidated Enterprises Page 1

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1 Advanced Accounting 74-B Taxation of Consolidated Enterprises Page 1 TAXATION OF CONSOLIDATED ENTERPRISES I. REPORTING OPTIONS FOR CONSOLIDATED FIRMS: A.Members of an "affiliated group" which meet IRC requirements may elect to be taxed as a single entity or as separate entities. B.IRC under the Tax Reform Act of 1984 states that an "affiliated group" exists only when the parent owns: 1. at least 80% of the voting power of all classes of stock (except the parent) and 2. at least 80% of the Fair Market Value of all the outstanding stock of subsidiary companies a. this stock must be: 1. entitled to vote 2. convertible 3. not limited and preferred as to dividends, redemption and liquidation rights II. ADVANTAGES OF THE ALTERNATIVE METHODS OF TAXATION A. Filing as a consolidated group 1. operating profits and losses are offset 2. capital gains and losses are offset 3. intercompany gains and losses are deferred until realized B. Filing as separate entities may also provide advantages: 1. Firms may use different tax years and alternative accounting methods 2. Significant intercompany losses which would be deferred on consolidated returns may be deducted immediately (Most of these losses are specifically disallowed under the IRC III. ACCOUNTING IMPLICATIONS A. Consolidated returns: 1. Consolidated income as determined on the working papers is the basis of tax expense; 2. Subsidiaries do not record any provision for income tax based on separate incomes; 3. Once the consolidated tax expense is calculated on the worksheet, it is allocated to and recorded on the books of the subsidiary firms. B. Separate returns: 1. Each subsidiary computes income tax expense based on its separate income (including intercompany items) as reported on its income statement; 2. Subsidiaries are entitled to normal deductions for: a. 80% of dividends from nonaffiliated, taxable domestic corporations; b. 100% of dividends from affiliated firms; 3. Because intercompany items are not excluded they result in timing differences that require interperiod tax allocation. a. to illustrate assume the downstream sale of equipment with a life of 5 years for a gain of $20,000. Consolidation procedures (GAAP) requires the gain to be deferred over the remaining life of the equipment. Tax rules (IRC) require that the gain be recognized in the period of the sale. Assuming "P" is in the 30% marginal tax bracket, tax allocation procedures would be: In the year of the sale: Deferred Tax Expense [(20k / 5yrs) x.30] x 4 yrs... 4,800 Provision for income taxes... 4,800 To record deferred tax expense necessary for interperiod tax allocation (NOTE: the $1,200 for the current year is not deferred due to IRC rules) In subsequent years: Deferred Tax Expense (for 3 remaining years)... 3,600 Provision for income taxes (current year)... 1,200 "P" RE (adjustment for 4 yrs expensed in yr 1) 4,800 IV. CONSOLIDATED TAX RETURNS: Filing as a consolidated entity A. Procedure: 1. Consolidated net income is determined on the worksheet in the normal manner; 2. tax expense is calculated as a part of the worksheet procedure; 3. Once calculated, the tax expense is allocated and recorded on the books of the individual firms.

2 Advanced Accounting 74-B Taxation of Consolidated Enterprises Page 2 B. Example --P purchases 80% of S on 1/1/1 and performed the following analysis on the investment: Analysis: Cost... $ 800,000 Purchased BV: Common stock... $ 500,000 RE (1/1/1) ,000 Total equity $ 900,000 Ownership interest... 80% 720,000 Excess of cost>bv = GW (40 yr life) $ 80,000 --On January 1, 19x2 P sold a piece of equipment with a net book value of $40,000 to S for $60,000. The equipment is depreciated by S on a straight-line basis over a 5-year life (Downstream Sale of depreciable equipment). --Assume a tax rate of 30%; --The following intercompany sales apply to P and S: Intercompany sales in beginning inventory (BOY) of P... $ 50,000 Intercompany sales in ending inventory (EOY) of S... 70,000 Sales to S during 19x ,000 Gross profit rate... 50% C. Solution:The following work sheet illustrates the procedures to accommodate the taxation of consolidated firms qualifying to file as an "affiliated group". Special attention should be paid to the following points: 1. The only difference from prior consolidated worksheets is item "I" which calculates the provision for income tax (notice that the amortization of goodwill had to be added back in that amortizations of excess of cost over book value are normally not deductible for tax purposes) 2. The distribution of consolidated income is made before tax, then this result is multiplied by (1 - the tax rate) to arrive at the after tax income (multiply by the tax rate to arrive at S tax itself). 3. It is necessary for each firm to record its share of the consolidated income tax on its own books: S entry: Provision for income tax... 37,500 Tax Payable (125,000 x.3)*... 37,500 "S" adjusted net income x tax rate See computation of MI NI for detail P entry: Provision for income tax... 35,700 Tax Payable (119,000 x.3)... 35,700 "P" adjusted net income x tax rate See computation of "P" NI for detail If P books entries (i.e. uses the "sophisticated equity method") it should also make the following entry to adjust the investment account for taxes: P entry: Subsidiary Net income... 30,000 Investment in S (37,500 x.8)... 30,000 PLEASE REFER TO THE WORKSHEET ON THE NEXT PAGE FOR A SUMMARY OF COMPLETE ELIMINATION PROCEDURES

3 Advanced Accounting 74-B Taxation of Consolidated Enterprises Page 3 Worksheet 1: Consolidated Worksheet for a Qualifying " Affiliated Group" Year ended 12/31/x3 Accounts Trial "P" Balance "S" Elims & Dr Adjstmnts Cr Consolid RE Minority Interest Controlling Retained Earn Consolidated Balance Sheet Cash 200, , ,000 Inventory 12/31/x3 150, ,000 (H) 35, ,000 Plant and Equip 900,000 1,100,000 (E) 20,000 1,980,000 Accum Depr-P&E (440,000) (150,000) (E) 8,000 (582,000) Investment in "S" 1,120,000 (A) 80,000 (B)960,000 (C) 80,000 Goodwill (C) 80,000 (D) 6,000 74,000 Liabilities (150,000) (150,000) "P" Common Stock (800,000) (800,000) "P" RE 1/1/x3 (900,000) (D) 4,000 (E) 16,000 (G) 20,000 (860,000) "S" C/S (500,000) (B) 400,000 (100,000) "S" RE 1/1/x3 (700,000) (B) 560,000 (G) 5,000 (135,000) Sales (600,000) (400,000) (F) 100,000 (900,000) CGS 350, ,000 (H) 35,000 (F)100,000 (G) 25, ,000 Expenses 100, ,000 (D) 2,000 (E) 4, ,000 Subsidiary NI (80,000) (A) 80,000 NI Before Tax (242,000) Provision for Tax (I) 73,200 73,200 Tax Liability (I) 73,200 (73,200) 1,383,200 1,383,200 Combined NI (168,800) To MI: 17,500 (17,500) To CI: 151,300 (151,300) Total MI 252,500 (252,500) RE, CI 12/31/x3 (1,011,300) (1,011,300) -0-

4 Advanced Accounting 74-B Taxation of Consolidated Enterprises Page 4 Supporting Computations/ Adjustments and Eliminations: Worksheet 1 (A) Eliminate Current Year Subsidiary NI: Subsidiary NI... 80,000 Investment in "S"... 80,000 (B) Eliminate Pro-Rata share of Investment in "S": "S" C/S (500,000 (.8)) ,000 "S" RE BOY (700,000 (.8)) ,000 Investment in "S" ,000 (C) Allocate the Excess of Cost>BV per analysis: Goodwill... 80,000 Investment in "S"... 80,000 (D) Amortize the Excess of Cost>BV per analysis: Amortization Expense (current year). 2,000 "P" RE (past years)(2,000 x 2 yrs)... 4,000 Goodwill (80,000/40 yrs)(3yrs)... 6,000 (E) Eliminate the gain on "Downstream" sale of Equip; Recognize portion allowable to date: "P" RE (Eliminate Gain)... 20,000 PP & E... 20,000 Recognize Gain to date at EOY 2: A/D PP & E (gain recog. to date)... 8,000 (20,000/5yrs)(2yrs) "P" RE (gain recog. in past)... 4,000 (20,000/5yrs)(1yr) Depreciation Expense (current yr)... 4,000 (F) Eliminate Intercompany Sales: Sales ,000 CGS ,000 (G) Eliminate Gain in BOY Inventory of "P" (upstream Sale): Inventory value = $50,000 "P" RE (25,000)(.8)... 20,000 Gross Profit.50 "S" RE (25,000)(.2)... 5,000 Profit in BOY = $25,000 CGS... 25,000 (H) Eliminate Gain in EOY Inventory of "S" (downstream Sale): Inventory value = $70,000 CGS... 35,000 Gross Profit.50 Inventory... 35,000 Profit in BOY = $35,000 (I) Record Provision for Income Tax: Income Tax Expense... 73,200 Consolidated Net Income... $ 242,000 Tax liability... 73,200 Add: Amort of GW not Allowed for tax. 2,000 Consolidated Taxable income... $ 244,000 Marginal Consolidated Tax rate Tax Liability... $ 73,200 Distribution of Net Income: To MI: MI % ("S" internally generated NI + intercompany upstream credits - intercompany upstream debits).2(400, , , ,000(G) =.2(125,000)*= $ 25,000 Less 30% ($25,000 x.30)... (7,500) MI... $ 17,500 *NOTE: $125,000 represents "S" Adjusted Net Income; that is to say "S" internally generated net income adjusted for the effect of Upstream intercompany transactions.

5 Advanced Accounting 74-B Taxation of Consolidated Enterprises Page 5 To CI: PIGNI + down cr - down dr + [("P"%)("S" Adjusted Net income)("s" tax rate)] [600k - 350k - 100k + 4k(F) - 2k(D) - 35k(H)] + [(.8)(125,000)(.7)] = $117, ,000 = $ 187,000 Less tax liability (117, ,000 GW not allowable for tax)(.3)... = ( 35,700) To CI... $ 151,300 NOTE: $117,000 represents "P" Internally generated net income; that is to say "P" internally generated net income adjusted for the effect of Downstream intercompany transactions. V. SEPARATE TAX RETURNS FILED BY MEMBERS OF THE CONSOLIDATED GROUP A. Procedure: 1. Tax liability is now based on the income of the separate entities; intercompany gains and losses are included thereby causing timing differences which will require an tax allocation. 2. Consequently, before P and S can be consolidated, it is necessary to calculate their separate tax liabilities. 3. The tax provision (expense) for "P" requires examination of the status of "S" ni allocable to "P" a. If conditions for a consolidated return are not met (not if the parent "elects" to file separately) the parent includes 20% of the dividends it receives from "S" in its taxable income. NOTE: If an "affiliated group" elects separate taxation, no dividends are included and no additional tax is calculated. b. IAW APB 23, subsidiary income included in the pretax income of a parent leads to a timing difference between the earning of income and its inclusion in the tax return as dividend income. c. APB 23 and SFAS 96 presumes all subsidiary income will be transferred to "P" unless: 1. There are definite plans on the part of the parent to reinvest the undistributed earnings of the subsidiary, which will allow indefinite postponement of their remittance to the parent; or 2. the earnings will be remitted as part of a tax-free liquidation. NOTE: If either of these two exceptions exist, "P" does not include "S" income in the computation of consolidated income and subsequent distributions B. Example: --P purchases 75% of S on 1/1/x1 and performed the following analysis of the investment: (note % is under 80% so seperate returns are required) Analysis: Cost... $ 285,000 Purchased BV: Common stock... $ 250,000 --"S" sells equipment to "P" on 1/1/x3 for $100,000 (BV to S was $60,000) --P is depreciating the equipment over 5 years (no salvage). RE (1/1/x1) ,000 --Income and expenses for "P" and "S" are stated on the worksheet on the Total equity... $ 350,000 following page Ownership interest: 75% 262,500 --The following data apply to intercompany merchandise sales to "S" by "P": Excess of cost>bv = $ 22,500 Intercompany sales in beginning inventory of S... $ 60,000 GW (20 yr life) $ 22,500 Intercompany sales in the ending inventory of S... 40,000 Sales to S during 19x ,000 Gross profit rate... 40%

6 Advanced Accounting 74-B Taxation of Consolidated Enterprises Page 6 --During 19x4 "P" and "S" reported the following operating incomes before tax: "P" "S" Sales... $ 430,000 $ 240,000 Less: CGS , ,000 Gross profit ,000 90,000 Less: Operating Expenses... 70,000 30,000 Operating income before tax $ 80,000 $ 60,000 --assume a 30% tax rate. 1. Assuming that the exceptions described in V,A,3,c,1 and 2 above do not apply, "P" must provide for tax expense equal to 20% of "S" net income. This is a secondary tax expense over and above the provision made by "S" on its books. For 19x4 this secondary tax expense required by "P" would be computed: "P" equity is "S" after tax net income To "P" (.75)(.7) * ($60,000)... $ 31,500 "P" tax expense (provision for tax) on "S" NI to "P" (.3)(.2)(31,500)... $ 1,890 "P" tax expense on internally generated NI (.3)(80,000)... 24,000 Total "P" tax expense for year x4... $ 25,890 * (1-tax rate) 2. Because "P" has not physically received is distribution from "S", the secondary tax is not liable and a deferred tax liability for $1,890 is recorded. The IRC recognizes the creation of a liability upon the receipt of dividends. Assuming that internally generated taxes are currently payable the following entry would be required: "P" tax expense (provision for income tax)... 25,890 Income tax payable... 24,000 Deferred tax (liability)... 1,890 C. SOLUTION: EXAMPLE 2 (CONSOLIDATED WORKSHEET FOR "NON-QUALIFYING" CONSOLIDATED FIRMS The completed worksheet for this example is found on the following page. The following points should be noted: 1. The balance of Investment account is computed normally. Cost... $ 285,000 Incremental Changes from date of purchase: Common stock Change in RE since acquisition (350, ,000) 250,000* *after tax expenses Total equity... $ 250,000 Ownership interest: (.75)(250,000) 187,500 Add: Equity in "S" NI (after tax) (.75)(.7)(60,000)... 31,500 Simple equity adjusted balance 12/31/x4... $ 504,000** **NOTE: this is "simple equity method" adjusted balance; amortizations must be included for "sophisticated equity method" (APB-18) balance 2. Since the parents share of undistributed income has been recorded from the date of acquisition, a deferred tax liability has been recorded by "P" each year. The total provision on 12/31/x4 is calculated: Deferred tax liability on 19x1-19x3 undistributed income: 19x1-19x3 inclusive ($187,500)(.2)(.3)... $ 11,250 19x4 (Current year deferral) (.2)(.3)(31,500)... 1,890 Total deferred tax liability... $ 13,140

7 Advanced Accounting 74-B Taxation of Consolidated Enterprises Page 7 Worksheet 2: Consolidated Worksheet for a "Non-Qualifying" Consolidated Group (Separate Returns) Year Ended 19x4 Accounts Trial "P" Balance "S" Elims & Dr Adjstmnts Cr Consolid RE Minority Interest Controll RE Consolid BS Cash 19,200 80,000 99,200 Inventory 12/31/x4 170, ,000 (H) 16, ,000 Plant and Equip 600, ,000 (E) 40,000 1,110,000 Accum Depr-P&E (410,000) (120,000) (E) 16,000 (514,000) Investment in "S" 504,000 (A) 31,500 (B)450,000 (C) 22,500 Goodwill (C) 22,500 (D) 4,500 18,000 "P" Common Stock (250,000) (250,000) "P" RE 1/1/x4 (510,450) (D) 3,375 (E) 24,000 (G) 24,000 (I) 15,408 (474,483) "S" C/S (250,000) (B) 187,500 (62,500) "S" RE 1/1/x3 (350,000) (B) 262,500 (E) 8,000 (I) 2,400 (81,900) Sales (430,000) (240,000) (F) 100,000 (570,000) CGS 280, ,000 (H) 16,000 (F)100,000 (G) 24, ,000 Expenses 70,000 30,000 (D) 1,125 (E) 8,000 93,125 Subsidiary NI (31,500) (A) 31,500 NI Before Tax (154,875) Provision for Tax 25,890 18,000 (J) 5,052 48,942 Tax Liability (24,000) (18,000) (42,000) Deferred Tax (13,140) (I) 17,808 (J) 5,052 ( 384) , ,360 Combined NI (105,933) To MI: 11,900 (11,900) To CI: 94,033 ( 94,033) Total MI 156,300 (156,300) RE: CI 12/31/x4 ( 586,515) ( 586,515) -0-

8 Advanced Accounting 74-B Taxation of Consolidated Enterprises Page 8 Supporting Computations/ Adjustments and Eliminations: Worksheet 2 (A) Eliminate Current Year Subsidiary NI: Subsidiary NI... 31,500 Investment in "S"... 31,500 (B) Eliminate Pro-Rata share of Investment in "S": "S" C/S (250,000 (.75)) ,500 "S" RE BOY (350,000 (.75)) ,500 Investment in "S" ,000 (C) Allocate the Excess of Cost>BV per analysis: Goodwill... 22,500 Investment in "S"... 22,500 (D) Amortize the Excess of Cost>BV per analysis: Amortization Expense (current year)... 1,125 "P" RE (past years)(1,125 x 3 yrs)... 3,375 Goodwill (22,500/20 yrs)(4yrs)... 4,500 (E) Eliminate the gain on "Upstream" sale of Equip; Recognize portion allowable to date: "P" RE (.75)(40,000)... 30,000 "S" RE (.25)(40,000)... 10,000 PP & E... 40,000 Recognize Gain to date at EOY 2: A/D PP & E (gain recog. to date)... 16,000 (40,000/5yrs)(2yrs) "P" RE (gain recog. in past)... 6,000.75(40,000/5yrs)(1yr) "S" RE (gain recog. in past)... 2,000.75(40,000/5yrs)(1yr) Depreciation Exp (current yr gain).. 8,000 (40,000/5yrs) (F) Eliminate Intercompany Sales: Sales ,000 CGS ,000 (G) Eliminate Gain in BOY Inventory of "P" (Dounstream Sale): Inventory value = $60,000 "P" RE... 24,000 Gross Profit.40 CGS... 24,000 Profit in BOY = $24,000 (H) Eliminate Gain in EOY Inventory of "S" (downstream Sale): Inventory value = $40,000 CGS... 16,000 Gross Profit.40 Inventory... 16,000 Profit in BOY = $16,000 (I) Adjust BOY RE for Interperiod Tax Allocation Effects of Prior Periods: 100% 25% 75% Total To MI To CI (E) tax on unamortized gain of upstream sale of equip paid by "S" (.3)(32,000)... $ 9,600 $ 2,400 $ 7,200 (F) "P" secondary tax on unamort after tax gain on up sale of equip (.3)(.2)(.75)(.7)(32,000) *.. 1,008 1,008 * (tax rate)(.20% dividend inclusion)("p" % ownership)(1-tax rate) (G) Prepaid tax on downstream sale of inventory (.3)(24,000)... 7,200 7,200 Changes to record in Retained Earnings accounts... $ 17,808 $ 2,400 $ 15,408 Deferred tax (liability)... 17,808 "P" RE... 15,408 "S" RE... 2,400

9 Advanced Accounting 74-B Taxation of Consolidated Enterprises Page 9 (J) Adjust the current years tax expense (provision) for: 100% 25% 75% Total To MI To CI (E) Current yr amortization of gain on upstream sale of equip pd by "S" (.3)(8,000)... $ 2,400 $ 600 $ 1,800 (F) Current yr amort. on secondary tax on up sale of equip pd by "P" (.3)(.2)(.75)(.7)(8,000) (G) Current yr amort on downstream sale of inventory (.3)(24,000)... 7,200 7,200 (H) Tax effect originating this year on profit in downstream sale of inventory (.3)(16,000)... (4,800) (4,800) Adjustments required in Current Year Tax Expense (Provision for tax)... $ 5,052 $ 600 $ 4,452 Distribution of Net Income: (Alternative computation, compare to V B 1 and 2) To MI: MI % ("S" internally generated NI + intercompany upstream credits - intercompany upstream debits).25(240k - 150k - 30k + 8,000(E) - 0 =.25(68,000) = $ 17,000 Less: Tax Liability (17,000 x.30)... 5,100 MI Net Income Distribution... $ 11,900 To CI: P adjusted NI = PIGNI + down cr - down dr + [("P"%)("S" Adjusted net income) = 430k - 280k - 70k + 24,000(G) - 16,000(H) = $ 88,000 Less tax (.30)(88,000)... 26,400 PIGNI after tax... $ 61,600 Add: P% ("S" Adjusted NI) = (.75)(68,000)... $ 51,000 Less tax (.3)(51,000)... (15,300) "P" share of "S" adjusted NI afer tax... 35,700 Deduct: Secondary tax on 20% of "S" NI (.20)(35,700)(.30) (2,142) Goodwill amortization not deductible for tax... (1,125) CI Net Income Distribution... $ 94,033