Because consolidated groups are not static, additional problems can arise when a member leaves a group that has an agreement that takes a wait-and-see approach. For example, if the tax allocation agreement takes a wait-and-see approach to compensating members for the use of their losses, and Subsidiary 2 deconsolidates the group at the end of year 2, then Subsidiary 2 will likely never be compensated for the group`s use of its loss without a specific provision in the agreement. To address this issue, many tax allocation agreements include deconsolidation provisions. For example, an agreement could require parent company 2 to compensate subsidiary 2 immediately after deconsolidation for the tax benefit of its losses previously absorbed by the group or absorbed by the group during the year of deconsolidation of the parent company. Alternatively, the agreement could require the parent company to compensate subsidiary 2 for any tax liability it incurs in the year following the consolidation if the liability had not arisen if subsidiary 2 had retained its separate business attributes previously assumed by the group. Tax allocation treaties should also address what happens when a member joins a consolidated group and has distinct corporate tax attributes (p.B. credit losses and carry-forwards) that can benefit the group. If there is a tax offset agreement, it could require the parent company to compensate subsidiary 2 if the loss of subsidiary 2 is absorbed by the group. Under this approach, a subsidiary is compensated for the loss of its tax attributes, whether or not those attributes would have been beneficial to it. Alternatively, some tax allocation agreements take a wait-and-see approach. Under this approach, Subsidiary 2 would not be compensated for the use of its loss in year 2.
Instead, the group would wait to see whether Subsidiary 2 would subsequently generate sufficient income to enable it to realize its loss, provided that the loss had not previously been absorbed by the scope of consolidation. If Subsidiary 2 continues to suffer losses, it can never be compensated for the profit that the group derived from its loss in year 2. Given the potentially significant difference in the payment schedule, care must be taken to ensure that all parties understand when members will be compensated for the use of their attributes. To date, most consolidated tax groups have decided to allocate their tax obligations on the basis of the theoretical individual taxable income of each group member or on the basis of the retained earnings of each member as a percentage of the group`s total accounting income. Whether or not the allocation is accepted as appropriate on these bases ultimately depends on the facts and circumstances that affect the tax situation of each group, as well as the laws, regulations and guidelines of the ATO that apply to tax sharing agreements in general. This is where a tax sharing agreement between the two companies comes in handy. The tax-sharing agreement will typically place the parent “instead of the IRS.” Using the example above, and assuming there is a consolidated group and tax-sharing agreement, the subsidiary would transfer $315,000 to the parent company. The parent company, which acts as the group agent, would pay the IRS $105,000 and withhold $210,000 in payment for the subsidiary using the parent company`s operating loss. Tax financing agreements complement tax-sharing agreements and specify how subsidiaries finance the payment of tax by the main company and when the main company must make payments to subsidiaries for certain tax attributes generated by subsidiaries that benefit the group as a whole (e.g.B tax losses and tax credits). In addition to federal income tax issues, there are several state tax issues that consolidated groups should address in their tax allocation agreements.
Although a full discussion of state taxes is beyond the scope of this article, it can have important implications, and changes in the state`s statutory rates or the company`s distribution factors from the year in which a loss is generated and the year in which the loss is absorbed by the group may raise allocation issues. In addition, the state taxes of the individual members of the group, calculated on an autonomous basis, are often different from the state taxes of the group, and tax allocation agreements need to address how to map these differences. Therefore, groups should work closely with their lawyers and tax advisors to ensure that their tax allocation agreement adequately addresses federal and state issues. Without a binding agreement, members are not required to pay the parent company their share of the tax payable to the group, and the parent company is not required to compensate members for the use of their tax attributes. To ensure that members receive adequate compensation for the group`s use of their tax attributes and that their assets are not depleted by excessive tax payments to the parent company, many tax advisors recommend that groups enter into legally binding tax allocation agreements that specify how cash tax payments and refunds are processed between members. A written tax clearing agreement is especially important if a group includes members who are regulated entities, who have minority shareholders, or who have external debt with separate financial obligations of the company. When multiple companies are consolidated into a large group, the parent company negotiates directly with the IRS, pays the group`s tax obligations, and receives all refunds. Tax allocation treaties are often used by members of a consolidated group to determine how to allocate and distribute these funds. The authors outline the issues that businesses need to consider when drafting such agreements, including how the carry-forward and presentation of net operating losses has been affected by the Tax Cuts and Employment Act, 2017. Tax financing agreements also determine the tax entries in the financial statements of members of the tax groups (i.e., deferred tax assets and deferred tax liabilities).
In addition to the distribution and allocation of tax refunds, tax allocation agreements should also explicitly state whether the parent company receives refunds in its capacity as group representative or whether the group intends the parent company to own the reimbursed amounts. In the absence of language that clearly communicates the group`s intentions, a parent company is more likely to be considered the owner if an agreement gives the parent company discretion as to whether to pay a subsidiary its share of a refund or offset that amount with the subsidiary`s future tax payments. Some courts have also argued that a parent company will be treated as the owner, unless the agreement explicitly requires refunds to be separated or restricted in use. Business groups are encouraged to consider entering into tax sharing agreements and tax financing agreements as part of their entry into the tax consolidation system. There are many ways in which tax allocation agreements could address this issue. For example, the agreement could stipulate that loss carry-forwards are absorbed proportionately in first-in and first-out proceedings. The consolidated income tax return rules provide that losses that may be absorbed in a consolidated reporting year are generally absorbed in the order of the taxation years in which they occurred and proportionately [Treasury Regulations, section 1.1502-21(b)(1)]. In the example above, this means that the group is treated as if it were involved in the loss of Subsidiary 1 in the amount of $533 (loss of $1,000 of the separate company year 3 ÷ $3,000 × $1,600 CNOL) and the loss of Subsidiary 2 in the amount of $1,067 (loss of $2,000 of the separate company ÷ consolidated loss of $3,000 × $1,600 CNOL) of the loss of Subsidiary 2 absorb. We have developed a wide range of precedents documenting tax sharing and tax financing agreements. .