Book Versus Tax Differences In Consolidations
Measuring the fair value of an equity interest in an acquired entity has become more complex not only in terms of the presentation of financial statements, but also combined interests have profound tax consequences which one must also take into consideration. Accounting consolidation rules have expanded to include Financial Interpretation 46, or FIN 46 for short, which replaces the term special purpose entity with the term Variable Interest Entities, or VIE’s. The rules evolved in the wake of the Enron scandal, however, before FIN 46 the guidance for consolidation accounting came from ARB No. 51, which was issued in 1958 and simply set consolidation guidance based upon voting interest of greater than 50 percent.
Rules for consolidation accounting reflect a trend away from defining control of another entity quantitatively and instead in terms of risks-and-rewards in a more qualitative approach for assessing control. There are now essentially two models for determining an entity should be consolidated for accounting purposes in which the rules assume that consolidated financial statements are more meaningful than separate statements and in which consolidated entities are defined not by what constitutes VIE’s but rather by what excludes them from qualifying as being consolidated under a risks and rewards model.
Codification of the VIE rules came into being in July 2009 with the advent of accounting standards codification, or ASC 810, in which an entity is deemed not to have a variable interest in which the following characteristics exist:
1. The power to direct the activities of a VIE that most significantly impact the VIE’s economic performance, and
2. The obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE.
While accounting rules have been broadened to require consolidation when equity interests alone are not sufficient to require it, by contrast, the Internal Revenue Code simply defines an affiliated group of corporations as ownership of at least 80 percent of the total voting power of another corporation and having a value of at least 80 percent of the total value of the stock of the corporation. Thus, it is more likely now that a company can be required to consolidate for accounting purposes, however, it will not be combined for tax purposes giving rise to a host of book-tax differences. It is the maintenance of the book-tax differences which constitutes an additional clerical burden on top of the myriad of VIE tests for determining whether an entity is consolidated or not.
A compelling argument for relying upon the relatively simple rules of ARB 51 and having a controlling voting interest is the many benefits of filing consolidated tax returns, especially in which the benefit of offsetting the profits of one entity against the losses of another is probably most notable. In the start-up arena for example, in which there are multiple investors each holding equal shares but who do not exercise equal control, provided there is one controlling financial interest which possesses significant decision-making ability, has the obligation to absorb expected losses, and has the right to receive expected residual returns then the entity is a VIE and is generally consolidated for financial statement presentation purposes, however, for tax purposes the entity will not be consolidated if the controlling interest is less than 80 percent.
Essentially, even if equity investors do not have an at-risk financial interest and do not direct the activities of the entity then the entity may be a VIE. On the other hand, if an entity is not thinly capitalized, meaning equity is sufficient and the investors meet the criteria of a control, the entity is generally not a VIE and is not consolidated. Nonetheless, it would be consolidated under the voting interest entity test if a single equity investor holds a majority voting interest or has a controlling financial interest in some other manner.
Perhaps a pragmatic way of approaching the application of the rules is by viewing them through the prism of whether key decisions are being made by non-equity interests, and whether backstopping losses and denying the right to receive returns identify nontraditional equity interests. However, the responsibility of determining whether consolidated financial statements are required also must take into consideration the tax benefits. Additionally, the aspect of record keeping of book versus tax differences must be balanced with the risks associated with an increased voting equity interest.
