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Tax accounting and provision simplification through restructuring

USA
1 Dec 2006

In light of recent heightened scrutiny of income tax accounting, many publicly held companies are reviewing their tax provision processes. Most of the review lately has been centered on ensuring compliance with FAS 109 (and now FIN 48), as well as documenting the income tax accounting process for SOX compliance. However, now may be the ideal time to focus on simplification. Rather than designing and implementing new controls to keep up with regulatory burdens, corporate tax departments should seek to simplify their processes, thus eliminating the need for many of the current controls. The desire for simplification is further bolstered by the looming implementation date for FIN 48. Just what can a company do to simplify its processes while adding value by minimizing its effective tax rate? One answer may lie in a thorough review of the corporate legal structure.

Complex Structures Cause Accounting Issues and Cash Tax Slippage

Many large companies' organizational structures consist of numerous partnerships, corporations, limited liability companies and other entities acquired or formed over the years, creating a complex tax landscape. The tax provision's complexity is further increased as the company expands operations in multiple states. FAS 109 (Accounting for Income Taxes) requires separate tax rates for deferred taxes for each jurisdiction where a company is subject to tax. Each state is a separate jurisdiction under FAS 109. In addition, if the company has multiple SEC registrants, effective tax rates must be calculated by each individual SEC registrant. Organizational complexity increases a tax department's workload, creates difficulty in complying with current (and proposed) accounting standards, and limits the ability of corporate tax departments to perform value-added functions.

An unfortunate result of corporate organizational complexity is inefficiency in state income tax. In many cases, state net operating losses (NOLs) are "trapped" in unprofitable corporate subsidiaries, while "pockets" of income are accumulated in other profitable corporate subsidiaries. The resulting state income tax rate is abnormally high because the "trapped" losses cannot offset the "pockets" of income on a separate company filing basis. The existence of "trapped" NOLs also creates potential valuation allowance issues under FAS 109 which negatively impact the company's tax rate.

The cause of these complex corporate organizational structures varies. Stock acquisitions often add to the organizational structure and can result in tax inefficiencies. There is sometimes an erroneous belief within organizations that it is necessary to incorporate to sufficiently limit legal liabilities. If these complex organizational structures form the basis for income tax accounting, a company's effective tax rate likely suffers and the overall provision process becomes burdensome and unnecessarily difficult.

Entity Elimination as an Answer to the Complexity and Inefficiencies

Liquidating or converting a legal entity to a disregarded entity is generally a simple task. But simplification of an organizational structure requires a lot of coordination, analysis and planning. It requires the efforts and cooperation of the corporate and business unit tax, accounting, legal, HR, regulatory and treasury functions. If provision simplification were the only goal (and legal, treasury and other issues didn't matter), some companies may be best positioned by operating all of their domestic business in one legal entity. However, simplification is not the only goal-cash tax savings is also a significant goal. The appropriate analysis will be to balance the simplification needs of the company with cash tax savings while addressing legal, accounting, treasury and HR issues that are impacted by the proposed restructuring. This is a highly analytical process, involving steps that are not always intuitive, but the results can be remarkable.

Restructuring Benefits-NOL Utilization

One of the benefits of these restructurings may be the revival and eventual utilization of net operating loss "trapped" within a corporate subsidiary. Many companies are under the false impression that net operating losses are eliminated upon the liquidation, conversion or merger of a corporate subsidiary. This is not usually the case. Most states follow IRC ?? 332, 368, 381 and 382 in determining whether net operating losses carry over to the entity surviving a restructuring. Certain states do not follow these federal provisions and care must be taken to ensure that the losses will survive as well as evaluating the impact of the likely lost basis in the stock of the disappearing entity.

Restructuring Benefits-Apportionment Review

Apportionment factors also play a major role in determining which subsidiaries should be liquidated or converted into disregarded entities. Part of the restructuring analysis entails a diligent review of the organization's unitary and nexus consolidated filing positions, as well as analyzing the organization's apportionment formulas. The apportionment data should be analyzed for correctness as well as for potential savings from factor dilution. During the course of this review, beneficial alternative formulas available among the various states where the resulting entities are operating may also be identified.

While it may be obvious to some, we encourage clients to reevaluate the possibility of combining tax paying entities with those entities that consistently produce losses, in order to produce the best state tax answer. In addition, the restructuring often leads to reversing of valuation allowance on state NOLs that were formerly "trapped." The result: provision simplification, current cash tax savings and deferred benefit (through elimination of valuation allowance).

Accounting Provision Simplification-The Business Purpose Behind the Restructuring

Today, more than ever, simplification of the tax accounting provision process should be the driver behind these types of corporate restructurings. The amount of transparency being required in corporate tax returns and SEC financials through various regulatory means (IRS Form M-3, FIN 48 and increased scrutiny of FAS 109 workpapers) and the growing emphasis on getting the financial statements 100% correct from a tax perspective has created an environment ripe for this analysis. Once successfully implemented, the restructuring should ease the burden on state income tax accounting (fewer state tax filers means fewer tax rate calculations, fewer (if any) valuation allowances and fewer state income tax returns) and free up resources in the tax department to focus on matters other than income tax accounting. The business purpose behind these restructurings may include the following:

Provision process simplification
Redeployment of resources (focus on planning instead of accounting)
Elimination of G&A expense associated with maintaining a separate legal entity
Potential alignment of legal entities and SEC registrants to facilitate corporate (or segment) reporting
Franchise tax savings (valid federal business purpose)
State income tax savings (valid federal business purpose)
Simplification alone should be enough to go forward with these projects. However, the cash tax savings and elimination of valuation allowances are nice side benefits.

We recommend that enterprises undertake a coherent analysis of a proposed restructuring that will achieve provision simplification, cash tax savings, valuation allowance elimination and other benefits. In this era of increased transparency and heightened scrutiny, corporate tax departments need to simplify everywhere they can. Simplification of the state income tax provision process will allow a corporate tax department to focus on the more judgmental areas of the tax provision (contingencies and valuation allowance). The SEC, FASB, Congress and the IRS have increased the regulatory burdens on corporate tax departments. These are necessary evils. A complex corporate organizational structure that exacerbates the regulatory environment may not be necessary and it can be simplified. For now, other than restructurings for simplification, we don't see a reduction to increased burdens on corporate tax departments from the recent changes to reporting requirements by the SEC, FASB or the IRS.

Taxand's Take

Taxand's Take Author