Did a subsidiary give taxable consideration by assuming deferred-tax, early-retirement, and warranty liabilities accrued on the transferor's financial statements?

Plain-English summary

A transferor proposed contributing less than 80 percent of its seller-activity tangible property to a subsidiary. The subsidiary would assume deferred-tax, early-retirement-program, and future-warranty liabilities that the transferor had accrued for financial-statement purposes.

The letter treated the assumed liabilities as consideration for the transferred assets. Under the cited accounting standard, accrual meant it was probable that a liability had been incurred and the loss could be reasonably estimated, even though later events would resolve the precise amount.

The letter distinguished future obligations arising only after the transfer for benefits the transferee itself receives, such as later rent under an assumed lease or future requirements and output contracts. Those post-transfer obligations would not necessarily be assumed indebtedness for the asset transfer.

Assumed facts, accounting basis, and source limits

Senior Staff Counsel Ronald L. Dick answered a June 22, 1993 letter from Mr. B--- D---. The requester expressly framed the facts as assumptions. A transferor required to hold a California seller's permit would contribute less than 80% of the tangible personal property held or used in that activity either to a new corporation for its first stock issuance or to an existing corporation without stock being issued. The subsidiary would also assume liabilities.

The deferred-tax reserve represented income-tax effects of book-versus-tax asset-basis differences, including accelerated tax depreciation versus straight-line book depreciation. The early-retirement reserve estimated a near-future program's cost. The transfer could happen before the offer period or during a September 1 through December 31, 1993 window—an October 1 transfer was the example—before some employees elected. The warranty reserve estimated future product-warranty costs from prior-year experience.

The requester asked whether assuming those accrued contingencies entered the assets' sale price. Counsel answered yes. Paragraph 8 of FASB Statement of Financial Accounting Standards No. 5 required loss-contingency accrual when pre-issuance information made an impairment or incurred liability probable and the loss reasonably estimable. Paragraph 1 described an existing condition whose possible loss would be resolved by later events. Because the stated liabilities had been accrued under generally accepted accounting principles and future confirmation was probable, their assumption was consideration for the transferred assets.

The letter then distinguished a June 1, 1987 Board legal-staff opinion supplied by Mr. Al Floria. That absent opinion said a subsidiary's liability arising after the property transfer for benefits it received afterward was not assumed indebtedness under Regulation 1595(b)(4). Counsel gave advance rent for the next month under an assumed lease, and later benefits and liabilities under third-party requirements and output contracts, as examples. Income-tax characterization did not control the sales-and-use-tax result.

The PDF does not include the June 22 request, June 1, 1987 opinion, asset or liability schedules, corporate records, stock or contribution instruments, contracts, lease, requirements or output agreements, financial statements, accounting workpapers, FASB source, tax-basis and book-basis schedules, depreciation records, retirement-plan documents, employee elections, warranty claims or experience, actuarial or reserve calculations, transfer date, title records, values, sale-price allocation, return, audit, assessment, payment, protest, appeal, or later outcome. It does not establish that the proposed transfer occurred or that any stated liability was actually assumed.

The live annotation preserves the seller's-permit assumption, less-than-80% transfer, three liability categories, financial-statement accrual, probability and GAAP rationale, consideration result, and August 5, 1993 date. It omits the hypothetical framing, new-versus-existing subsidiary and stock alternatives, detailed deferred-tax, retirement-window and warranty facts, FASB Statement No. 5 and quoted paragraphs, request to determine sale price, June 1, 1987 contrary opinion, Regulation 1595(b)(4), post-transfer-benefit distinction, lease and operating-agreement examples, income-tax warning, missing records, proposed posture, and absent tax outcome.

What this means for you

Businesses transferring assets with reserves

Calling a liability contingent does not remove it from consideration when financial statements already recognize a probable and estimable obligation.

Accountants and tax professionals

Separate liabilities incurred before transfer from obligations that arise afterward for benefits delivered to the transferee. The accounting record is evidence, though income-tax characterization is not controlling.

Common questions

Q: Which accrued liabilities were analyzed?
A: Deferred taxes, estimated early-retirement costs, and future product-warranty costs.

Q: Why did they count as consideration?
A: They had been accrued because a loss was probable and reasonably estimable, so the subsidiary assumed existing economic obligations.

Q: Does every assumed future payment count?
A: No. The letter distinguished obligations arising after transfer for benefits the transferee receives later.

Q: Did income-tax treatment decide the sales-tax result?
A: No. The letter expressly said income-tax characterization was not determinative.

Q: What accounting standard supported the result?

A: Counsel quoted paragraphs 1 and 8 of FASB Statement of Financial Accounting Standards No. 5 on existing loss contingencies that are probable and reasonably estimable.

Q: Did the letter establish that the transfer occurred?

A: No. The requester supplied assumed facts, and the source contains no executed agreement, transfer, tax filing, audit, assessment, or later outcome.

Citations and references

• California Sales and Use Tax Regulation 1595(b)(4)
• FASB Statement of Financial Accounting Standards No. 5, Accounting for Contingencies, paragraphs 1 and 8
• June 1, 1987 Board legal-staff opinion concerning assumed contingent-liability reserves — described and quoted in part but not included
• June 22, 1993 request and transaction, corporate, asset, liability, accounting, allocation, transfer, tax, administrative, and outcome records — described or implicated but not included

Verbatim support

From the official August 5, 1993 Senior Staff Counsel letter:

Yes, we believe the transferee assuming the contingent liabilities is consideration given for the assets.

Given that it is probable that future events will occur confirming the fact of the contingent liabilities you noted, and the liability is accrued in accordance with generally accepted accounting principles, we believe the transferee's assumption of the liability is consideration given for the assets transferred.

Where the subsidiary incurs liabilities which arise after the transfer of tangible property, and are for benefits received by the subsidiary after that transfer, this is not assumed indebtedness within the meaning of Regulation 1595(b)(4), and therefore does not constitute taxable consideration for the transfer.

As noted in the June 1, 1987 memorandum, we do not consider the characterization of the liabilities for income tax purposes to be determinative for sales and use tax purposes.

Source

• Annotated Legal Opinions collection: CDTFA Annotated Legal Opinions
• Annotation page: Annotation 395.0100
• Original supporting opinion: 395.0100 PDF

Original ruling text

395.0100

STATE OF CALIFORNIA

STATE BOARD OF EQUALIZATION

MEMBER
First District

450 N STREET, SACRAMENTO, CALIFORNIA
(P.O. BOX 942879, SACRAMENTO, CALIFORNIA 94279-0001)
(916) 445-6450

BRAD SHERMAN
Second District, Los Angeles
ERNEST J. DRONENBURG, JR.
Third District, San Diego
MATTHEW K. FONG
Fourth District, Los Angeles

August 5, 1993

GRAY DAVIS
Controller, Sacramento

BURTON W. OLIVER
Executive Director

Mr. B--- D----- --XXX South --- Street
--- ---, CA XXXXX-XXXX
Dear Mr. D---:
This is in reply to you June 22, 1993 letter requesting our opinion as to the application of sales tax to the following facts you described: "For purposes of this ruling assume the transferor is required to hold a California Seller's Permit due to its activities in the State and will transfer less than 80% of the tangible personal property held or used in the course of such activities. The assets will be contributed to either a new corporation in exchange for the first issuance of stock ... or to an existing corporation with no stock issued in exchange.... In addition to the assets being transferred, certain liabilities will be transferred and assumed by the subsidiary. Included in these liabilities will be the following contingent liabilities that have been accrued for financial statement purposes and that we believe are not taxable consideration due to their contingent nature:
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Deferred Taxes - This amount represents the income tax effect of differences between the company's book and tax basis of assets. For example, it includes tax on the temporary difference that results from the company's use of accelerated depreciation methods for income tax purposes versus straight line depreciation for book purposes.

-

Early Retirement Program - The company is offering an early retirement program in the near future. The company has established a contingent liability for its estimate of the cost that will ultimately be associated with this program.

Mr. B--- D---

-2-

-

August 5, 1993
395.0100

A)

The transfer of assets and liabilities may occur prior to the period during which the early retirement program will be offered.

B)

The transfer of assets and liabilities may occur during the window period for which the early retirement program is offered. However, certain employees will not yet have elected to participate in the early retirement program as of the asset transfer date (e.g., period to elect to participate in the program is 9/1/93 - 12/31/93. Assets are transferred on 10/1/93). Accordingly, at the transfer date a portion of the liability associated with this program will still be contingent since such liability will relate to the estimate of the number of employees that will ultimately elect the program.

Warranty Liability - A reserve has been established for future product warranty costs based on the company's experience with such costs in prior years.

Given this information, you asked that we confirm whether this Board would consider the assumption of any of the contingent liabilities discussed above to be part of the sale price of the assets. Yes, we believe the transferee assuming the contingent liabilities is consideration given for the assets. As you noted, each of the liabilities has been accrued for purposes of reporting on financial statements. The Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No.5, Accounting for Contingencies (FAS5) provides at paragraph 8 that: "8: An estimated loss from a loss contingency (as defined in paragraph 1) shall be accrued by a charge to income if both of the following conditions are met: a.

Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.

b.

The amount of loss can be reasonably estimated." (Emphasis in original.)

Paragraph 1 of FAS5 defines a loss contingency as an existing condition, situation, or set of circumstances involving uncertainty as to possible loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. Given that it is probable that future events will occur confirming the fact of the contingent liabilities you noted, and the liability is accrued in accordance with generally accepted accounting principles, we believe the transferee's assumption of the liability is

Mr. B--- D---

-3-

August 5, 1993
395.0100

consideration given for the assets transferred.
Mr. Al Floria sent for our review opinion from the Board's legal staff dated June 1, 1987 which concluded that a subsidiary's assumption of reserves for contingent liabilities did not constitute consideration. That opinion was based on the view that, "Where the subsidiary incurs liabilities which arise after the transfer of tangible property, and are for benefits received by the subsidiary after that transfer, this is not assumed indebtedness within the meaning of Regulation 1595(b)(4), and therefore does not constitute taxable consideration for the transfer." An example of a liability which arises after the transfer and is for benefits received by the transferee after the transfer, would be the transferee assuming the transferor's lease. For instance, if the transferor's lease agreement requires rental payments to be made in advance, then the transferee's liability for a rental payment would be for a benefit (the next month's rent) the transferee receives after the transfer. There are other agreements, often referred to as operating agreements, which we would treat in the same manner. These would include requirement and output contracts with third parties for benefits and liabilities not yet received or incurred. As noted in the June 1, 1987 memorandum, we do not consider the characterization of the liabilities for income tax purposes to be determinative for sales and use tax purposes. Sincerely,

Ronald L. Dick
Senior Staff Counsel
RLD:ph