Misleading Tax Figures-A Problem for Accountants

Misleading Tax Figures-A Problem for AccountantsAuthor(s): Richard P. WeberSource: The Accounting Review, Vol. 52, No. 1 (Jan., 1977), pp. 172-185Published by: American Accounting AssociationStable URL: http://www.jstor.org/stable/246040 .

Accessed: 12/06/2014 21:47

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact [email protected].

.

American Accounting Association is collaborating with JSTOR to digitize, preserve and extend access to TheAccounting Review.

http://www.jstor.org

This content downloaded from 91.229.229.49 on Thu, 12 Jun 2014 21:47:29 PMAll use subject to JSTOR Terms and Conditions

http://www.jstor.org/action/showPublisher?publisherCode=aaasoc

http://www.jstor.org/stable/246040?origin=JSTOR-pdf

http://www.jstor.org/page/info/about/policies/terms.jsp


THE ACCOUNTING REVIEW Vol. LII, No. I January 1977

Misleading Tax Figures A

Problem for Accountants

Richard P. Weber

ABSTRACT: Some corporate groups that file consolidated returns use different methods to allocate the consolidated tax liability for tax return and financial reporting purposes. Such dual allocations can cause the tax liability reported in an affiliate's financial statements to differ from the liability it reports to the Internal Revenue Service. This is not a "timing" or "permanent" difference as the terms normally are used. Differences arising from dual allocations are the focus of this paper.

The paper examines the allocation of consolidated tax liabilities. An illustration is used to demonstrate the allocation methods specified for tax purposes, and the fact that the results of these methods generally do not conform to sound accounting practice is noted. An allocation method consistent with sound accounting practice then is proposed. Finally, the practice of using different allocation methods for tax and financial reporting purposes is examined, and the need for action by the accounting profession in this area is pointed out.

M ISLEADING income tax liabilities may be reported when corporations which file consolidated

income tax returns publish separate financial statements. If different methods are used to allocate a consolidated tax liability among the affiliates for tax and financial reporting purposes, misleading tax figures can result. In this circum- stance, an affiliate's tax liability as reported on the group's tax return may be different from that reported in the affiliate's financial statements. (Differences due to allowances for audit adjustments are ignored in this paper; those caused by timing factors are given incidental consideration.) Financial statements reporting a tax liability different from the tax owed to the government appear to violate generally accepted accounting principles and, thus, could be considered misleading. In spite of this apparent potential for violating accounting principles, consolidating groups do use differ-

ent allocation methods for tax and financial reporting purposes, as was docu- mented by Wheeler and Galliart [1974, p. 158]. These authors found that six of eleven groups faced with the problem of allocating consolidated tax liabilities used different allocation methods for tax and financial reporting purposes. However, neither the actual allocation methods used by the groups for tax and financial reporting nor the differences between those methods was disclosed. It is certain, though, that the allocation methods used for tax purposes are governed by the rules of the Internal Revenue Code of 1954.

Apart from discrepancies in tax figures arising through the use of dual allocation systems, the tax allocation formulas themselves appear to breach generally

Richard P. Weber is Assistant Professor of Accounting at The University of Wis- consin at Madison.

172



Weber 173

accepted accounting precepts. In the following pages, the methods used to allocate consolidated tax liabilities for tax purposes are examined and applied in a specific example. The results of the various tax allocation methods then are discussed in light of financial accounting principles. Accounting problems raised by these dual allocations are then considered, and some research needed in this area is specified.

TAX CONSOLIDATIONS

When two or more corporations are related through at least 80 percent common ownership and have a common parent corporation, a consolidated tax return election generally is allowed by Section 1552 of the Internal Revenue Code of 1954 (hereafter Section). Because of the differential impact of the tax law on consolidating as opposed to non- consolidating entities, the tax liability under such an election seldom equals the sum of the tax liabilities that would be incurred if each member filed a separate return. A major, but "temporary," difference arises because intercompany gains and losses usually are deferred when consolidated taxable income is computed. Once the consolidated tax liability is determined, it is allocated to the affiliates according to a formula elected by the parent corporation, which may choose among nine allocation methods specified in the Code and Regulations. Or, the parent may use any other method, subject to the commissioner's approval.

SPECIFIED ALLOCATION METHODS

Three tax allocation methods are specified by Section 1552. Three more allocation methods are available when the Section 1552 methods are modified according to Treasury Regulation 1.1502- 33(d)(2)(i). Three additional methods are created when the statutory formulae

are modified by Regulation 1. 1502- 33(d)(2)(ii). The nine specified methods are discussed briefly below.

The first statutory method allocates the tax in proportion to each affiliate's positive contribution to consolidated taxable income. The second statutory method allocates the tax in proportion to each affiliate's prospective separate return tax. This prospective tax is computed by applying the tax law to the member's contribution to consolidated taxable income. Statutory method three is a hy- brid of methods one and two. It initially allocates the tax according to method one, but in some cases the tax is re- allocated if a member's initial allocation exceeds its method two separate return tax. All three methods consider only income and deductions reported on the current year's consolidated return. They do not consider taxes allocated in other years, and they fail to compensate a member who furnishes a tax benefit to the group.

The two general modifications specified in the regulations attempt to remedy shortcomings of the code methods. The first modification considers the total allocation to each affiliate over all the years in which it joins in the group's return and for which the group elected this modification. This modification com- pares the member's total allocation to the member's total prospective separate return tax for the same period. If a member's allocation is in excess of its separate return tax, and if other members have separate return taxes in excess of their total allocations, the former excess tax is redistributed. This redistribution is ac- complished by simultaneously reducing allocations that exceed the corresponding separate return taxes and increasing allocations that are less than the corresponding separate return taxes. The second modification attempts to compen-



174 The Accounting Review, January 1977

FIGURE I

POTENTIAL TAX LIABILITIES: AN ILLUSTRATION

Total Independent Consolidated

EntitY' P S T P+S+T P-S-T

Ordinary income $400,000 $100,000 <$15,000> $485,000 $485,000 1231 transactions:

Outsiders <$ 30,000> $ 25,000 $ X- <$ 5,000> <$ 5,000> S to P $ 10,000 $ 10,000

Contributions: Actual ($ 20,000) ($ 5,000) $ -0 ($ 25,000) ($ 25,000) Deductible ($ 18,500) ($ 5,000) $ -0 ($ 23,500) ($ 24,000)

As independent entities: Tax $155,220 $ 42,600 $ -0- $197,820 $205,380 Taxable income $351,500 $130,000 ($15,000) $466,500 $456,000

Reconciliation of independent and Section 1552 taxable income:

Increases T's loss not considered $15,000 $ 15,000

Decreases Intercompany sale <$ 10,000> <$ 10,000> Change in contribution limit <$ 500> <$ 500>

Section 1552 taxable income $351,000 $120,000 $ -0- $471,000

sate members for tax benefits furnished to the group during the current year. This modification usually results in a redistribution of the consolidated tax when an affiliate's tax allocation is less than its prospective separate return tax. A more detailed treatment of these methods is presented in the appendix, which con- tains the various specified methods in flowchart form.

ILLUSTRATION OF SPECIFIED

ALLOCATION METHODS

The Situation Application of the nine allocation

methods is illustrated in Figures 1 and 2 and in the following discussion. P. S and T are corporations which started operations in 1975, the year for which the tax is computed below. T's regular operations resulted in a net loss of $15,000; regular operations of P and S resulted in earnings of $400,000 and $100,000, respectively. From Section 1231 transac-

tions with unrelated parties, P recog- nized a $30,000 loss and S a $25,000 gain. Section 1231 gives capital gains treatment to net gains from transactions in- volving certain business property while allowing net losses to be treated as ordinary losses. In addition S realized a $10,000, Section 1231 gain on a sale to P of land which S used in its business. Corporation T incurred no Section 1231 transactions in 1975. Charitable contributions by P, S and T were $20,000, $5,000 and $-0-, respectively.

As independent corporations P. S and T would pay a total tax of $197,820 (see Figure 1), attributable as follows: P $155,220, S $42,600 and T $-0-. While T, because 1975 is its first year of opera- tion and thus has no taxable income in previous years, cannot carry its loss back, it can carry the loss forward to offset taxable income earned during the next 5 years. As a consolidated group, these corporations would pay a tax of $205,380



Weber 1 75

on the same business transactions. The $7,560 tax increase results from the following five divergent factors:

1. T's loss reduces the tax by $7,200 ($15,000 x 0.48) because it currently is deductible on the consolidated return.

2. Deferral of the gain on S's sale of land to P reduces the tax by $3,000 ($10,000 not taxed at the 30 percent capital gains rate).

3. Loss of one surtax exemption, due to affiliation (an exemption is lost even if the affiliates elect not to con- solidate) increases the tax by $13,500

($25,000 x (0.48 - 0.20) + $25,000 (0.48-0.22)). (The 1975 surtax exemption allows the first $25,000 of taxable income to be taxed at a 20 percent rate, with the second $25,000 taxed at a 22 percent rate. The remaining ordinary income is subject to a 48 percent total tax. Thus, each 1975 surtax exemption is worth $13,500 ($25,000 x (.48- .20) + $25,000 x (.48 -.22)). Note that the group actually lost two surtax exemptions. However, since T's exemption was also lost on an independent basis because of T's operating loss, the net exemption

FIGURE 2 POTENTIAL ALLOCATIONS OF THE CONSOLIDATED TAX

Entity P S T Total

Tax as independent entities $155,220 $42,600 $ $197,820 Allocation bases:*

Section 1552 taxable income $351,000 $120,000 $-0- $471,000 Section 1552 tax $161,730 $46,350 $208,080 Section 1502 tax $161,970 $49,350 $211,320

Allocations using** Ml $153,054 $52,326 $-O $205,380 M2 $159,631 $45,749 $-0-- $205,380 M3 $159,030 $46,350 $-0- $205,380 M I - I $156,030 $49,350 $-0- $205,380 M2-1 $159,631 $45,749 $-0- $205,380 M3-1 $159,030 $46,350 $-0- $205,380 M 1-2 $161,730 $50,850 <$7,200> $205,380 M2-2 $161,730 $46,350 <$2,700> $205,380 M3-2 $161,730 $46,350 <$2,700> $205,380

Maximum allocation $161,730 $52,326 $- Minimum allocation $153,054 $45,749 <$7,200>

Range of allocation $ 8,676 $ 6,504 $7,200

As a % of independent entity tax:*** Maximum allocation 1050% 1230 % Minimum allocation 990% 107% /0

Range of allocation 6% 16% X0 %

* See the appendix for definitions of 1502 and 1552 taxable income and tax. ** M I designates code method one unmodified, M 1-2 designates code method one with regulations modification

two, etc. *** These statistics are a function of the particular situation reflected in the example. Other situations might show

either narrower or wider ranges.




loss arising from affiliation is only one.)

4. A $240 ($500 x 0.48) decrease results because the group's charitable contributions limit (5 percent of its taxable income before the contribution deduction) is $500 greater than the sum of the independent corporation limits.

5. The combination of P's Section 1231 loss with S's gain on the consolidated return increases the tax by $4,500 ($25,000 x(0.48-0.30)).

Computation of the Allocation Bases

The allocation bases (Section 1552 taxable income and tax and Section 1502 tax in Figures 1 and 2) used to apportion the consolidated tax liability can be determined by starting with the independent corporation taxable income figures. Thus, as shown in Figure 1, the members' Section 1552 taxable incomes are computed as follows:

1. T's $15,000 loss is adjusted to $-0- because Section 1552 considers only positive contributions to consolidated taxable income.

2. S's $130,000 income is decreased by $10,000 to $120,000 because S's gain on the sale of land to P is deferred on consolidation.

3. P's $351,500 income is decreased to $351,000 to account for the additional $500 of charitable contributions deduction allowed due to consolidation.

The Section 1552 separate return taxes (designated Section 1552 tax in Figure 2) are computed by applying the appropri- ate tax rates to each corporation's Sec- tion 1552 separate return taxable income. In applying the rates, the group's $50,000 surtax exemption is divided equally between P and S. Thus, the tax rates used are 20 percent of the first $12,500 of tax-

able income, 22 percent of the next $12,500 and 48 percent of the remainder. A 30 percent rate is applied to S's Section 1231 gains. The resulting Section 1552 separate return taxes for P, S and T are $161,730, $46,350 and $-0-, respectively. The Section 1502 separate return taxes (designated Section 1502 tax in Figure 2) are computed by applying the above tax rates to the independent company taxable income. Again, the group's surtax exemption is divided equally between P and S. Thus, P's, S's and T's 1502 taxes are $161,970, $49,350 and $-0-, respectively.

The Allocations

The tax distributions that would be produced by the nine specified allocation methods are computed by using the bases just developed. Method one (Ml)', which allocates the tax in proportion to positive Section 1552 taxable income, would assign $153,054 to P, $52,326 to S and $-0- to T. (See Figure 2.) Method two (M2), which allocates in proportion to Section 1552 taxes, would assign $159,631 to P, $45,749 to S and $-0- to T. Method three (M3) which, in this case, would limit S's allocation to the amount of its Section 1552 tax, would assign to P, $159,030; to S, $46,350; and to T, $-O-. Electing modification one would not affect the results produced by statutory methods two (M2-1) and three (M3-1), since no member's allocation would be greater than its Section 1502 tax. However, modification one would affect the method one allocations (MI-1) because S's method one allocation would be greater than its Section 1502 tax of $49,350. Thus, modification one would reduce S's allocation to $49,350 and increase P's allocation to $156,030. T's allocation would remain $-0-. Electing

I This and similar references which follow identify the allocations being discussed as they are presented in Figure 2.



Weber 177

modification two would increase P's allocation under all three statutory methods to $161,730, since P's unmodified allocation would be less than its Section 1552 tax. Under statutory method two, S's unmodified allocation also would be less than its Section 1552 tax, therefore, S's allocation would be increased to $46,350. With either modified statutory method two (M2-2) or three (M3-2), the entire increase would be used to compensate T for the use of its net operating loss. With either method T's compensation would be $2,700, the sum of the tax increases to P and S. In neither case would the compensation equal the $7,200 ($15,000 x 0.48) tax value of T's loss. Modification two combined with method one (M1-2) would cause P's tax to increase by $8,676 ($161,730- $ 153,054). In this case, T's compensation would be $7,200, the maximum possible value of its loss. The remainder of P's increase would be used to compensate S for the loss of benefits from its Section 1231 gains. Thus, S's allocation would be reduced from $52,326 to $50,850.

DISCUSSION OF THE ALLOCATIONS

The illustration shows how a relatively straightforward tax situation can give rise to many different allocations of the consolidated tax. Clearly, all allocations cannot be equally acceptable for financial reporting purposes. In the following discussion the nine separate allocation methods are examined in light of the accounting entity concept as it applies to the statements of individual affiliates. The entity concept is one of the basic features of accounting [AICPA, 1970, p. 44]. Under this concept, all economic units, including individual corporations and consolidating groups of corporations which are accounted for separately, are treated as independent units in pre- paring any required financial statements.

These statements reflect the entity's transactions with all other entities in the world as they are effected through market transactions. Thus under the entity concept a corporation's tax liability should not be affected by other corporations' actions except when those actions impact through an open market. Unless other- wise stated, the ensuing discussion pre- sumes that the allocated tax and the financial statement tax liability are the same. It is assumed further that any differences between the tax expense and liability are due solely to timing factors.

T's Potential Allocations

If T's taxable and financial net income before taxes are the same, T as an independent corporation would report no income tax liability or expense for the year. The only reference to the income tax that would appear in T's financial statements would be a footnote inform- ing the reader of potential tax benefits available through the code's net operating loss carry-forward provisions. These provisions would allow T to deduct the $15,000 loss from taxable income during the next 5 years.

The loss's tax consequences are different when T joins in a consolidation and are dependent upon the group's elected allocation method. If any of the statutory methods (MI, M2 and M3) were elected without modification, T's share of the liability would be zero. Corpora- tion T also would have no loss carry forward since the loss would have been used to reduce the group's taxable income. Thus, under the unmodified statutory methods, T never would receive a tax benefit from its loss. This situation is inconsistent with the accounting entity concept in that a tax savings generated by one entity may be removed perma- nently from that entity's statements due to actions of other entities.




Modification one combined with any of the statutory allocation methods (MI-1, M2-1, M3-1) would give results that are more in accord with the accounting entity concept. With modification one, T's allocation would still be $-O- in all cases. However, if T has taxable income in future years while par- ticipating in the consolidation, T might benefit from its own loss. Whether or not T benefits from its own loss, it might, due to consolidation, benefit from a net operating loss incurred in the future by either P or S. This situation would be analogous to an independent corporation's loss carry forward; T, in essence, would carry the loss forward as long as the group continued its election of modification one. However, note, that T's tax benefit is contingent upon either P or S deriving net tax savings from consolidation. Allocations computed using the statutory methods combined with modification one are generally less objectionable than those given by the unmodified statutory methods. Yet the results are still not completely sound since they make one corporation's tax benefits contingent on another corporation's tax savings.

Combining the statutory allocation methods with modification two (M1-2, M2-2, M3-2) would give somewhat un- usual results in the case of T. With modified method one, T immediately would be paid its loss's maximum tax saving value, $7,200 (15,000 x 0.48), de- spite the fact that under the best circum- stances T, as an independent, could only realize the $7,200 benefit a year later. In other words, T would be overcompen- sated by at least one year's interest on $7,200. If method two or three were combined with modification two, T would receive $2,700 as compensation for a benefit which saves the group $7,200. As with modification one, the problem is that the amount of "savings from con-

solidation" realized by other affiliates would determine T's compensation. Thus, depending on how the consolidation affects the other affiliates, T's compensation could range from $7,200 to to $-O-. As with other allocations, the potential allocations given by modification two would be objectionable because the taxes reported in T's statements would be a function of other corporations' income and taxes.

S's Potential,411ocations The effects of the allocation formulae

on S's tax liability would be more complex. Corporation S's separate statements would reflect timing differences as well as the effects of the allocation formulae. A timing difference would result from S's $10,000 gain on land sold to P. The consolidated tax liability would not reflect this gain, but S's separate tax statements would. Therefore, S would have to report a deferred tax credit (liability). The theoretical importance of this and other timing differences is not considered because they only affect future years' allocations. The remaining differences between S's tax as an independent corporation and its potential consolidated tax allocation again would violate the accounting entity concept. Consolida- tion would cause S's tax to increase because:

1. Corporation S would be denied a full surtax exemption.

2. A change in tax rates would result from the consolidation of Section 1231 gains and losses.

In addition, all the allocation methods, except method one combined with modification two, would decrease S's tax because of T's operating loss. These effects would not be consistent with the accounting entity concept, because S's



Weber 179

tax would be a function of both P's and T's transactions as well as its own. Another issue would be raised if any statutory method and modification one were used. How would S account for its potential obligation to compensate T for having used T's loss?

P's Potential Allocations

The effects of the tax consolidation provisions on P's taxable income would be complex. If P were treated as a consolidating affiliate, its taxable income would be reduced by $500 because of an increase in the allowed charitable contributions deduction. How this addi- tionally deductible $500 and the $1,000 of contributions carried forward would be accounted for is not entirely clear; it is probable that P (as an affiliate) would deduct the $500 and set up a deferred charge to reflect the $1,000 carried forward. The point is that the entity concept would be breached because the actions of S and T would change the amount of P's deductions. However, the difference it- self would not be of great importance, since it would result from timing factors and, in any case, probably would reverse in future years.

The net effect of applying different allocation formulae to the consolidated tax would be less important for P than for S and T. Corporation P's allocated liability would, like the liabilities of affiliated S and T, be a function of other corporations' transactions. However, P's separate statements, unlike those of S and T, would reflect P's proportionate share of S and T's after-tax income under Ac- counting Principles Board Opinion No. 18. Thus, if S and T were wholly owned by P, the net effect of a shift in tax liabilities among P and its subsidiaries, brought about by an allocation method, simply would be a reclassification between P's tax expense and income from subsidi-

aries. There would be no effect on P's net income. If S and T were not wholly owned, the major effect of any tax shift caused by the allocation method still would be reclassification, since at least 80 percent of the subsidiaries' income must appear on P's statements. Thus, because of required equity accounting, the violation of the entity concept caused by the allocation of consolidated tax liabilities would be less significant in the case of P than in the case of S or T.

A Possible Solution

Though none of the existing allocation methods give results that are consistent with good accounting practice, it is possible to allocate a consolidated tax liability and not violate the entity concept. This can be done by allocating to each affiliate, except the parent, a share of the consolidated tax equal to the tax it would have paid (been refunded) if it had filed a tax return as an independent corporation. The parent's tax then would be the consolidated tax less the tax assessed on all of the other affiliates. Using this method in the preceding situation would assign a tax of $162,780 to P, $42,600 to S and $0 to T. In addition, T would carry its loss forward, and P would carry the $1,000 of denied charitable contributions forward. In other words, this allocation method would apply the tax law to each of the subsidiaries as a separate entity. Only the parent's tax would be affected by the tax consolidation; however, as noted earlier, this violation of the entity concept would be reduced substantially or eliminated by accounting for the parent's investments in the subsidiaries under the equity method.

The suggested allocation method also can be defended on equitable grounds. It would cause both the benefits and the detriments of consolidation to flow through to the parent which caused the consolidation in the first place.




DIFFERENT ALLOCATION METHODS

FOR TAX AND ACCOUNTING?

Even if the proposed allocation method were adopted for financial reporting, the problem of dual allocation methods would remain. To illustrate this problem, suppose that P-S-T, the consolidating group from the example, elected to allocate the consolidated tax according to statutory method one (M1) for tax purposes and according to the same method with modification two (M 1-2) for financial reporting purposes. In that situation, T's separate financial statements would reflect a tax refund of $7,200 (see Figure 2) which would not exist. This permanent difference is not covered by Accounting Principles Board Opinion No. 11 [p. 159]. The reporting of such deceptive tax figures seems to violate the general presumption that reported amounts reflect actual assets and liabilities of the entity concerned. Yet such dual allocations are used according to Wheeler and Galliart [1974, p. 158] and, presumably, CPA's are giving clean opinions on these statements. This ap- parently unacceptable practice may be a pragmatic- response to the problems noted in this paper and to the lack of guidance by the accounting profession in this area.

A LACK OF PROFESSIONAL GUIDANCE

In spite of the problems noted in this discussion, consolidated tax returns, and particularly the allocation methods used in conjunction with the returns, have received very little attention from the accounting establishment. The pronounce- ments of the American Accounting Asso- ciation, the American Institute of Certi- fied Public Accountants, the Financial Accounting Standards Board and the Securities and Exchange Commission do not address the issue of allocating consolidated tax liabilities. In particular,

Accounting Research Bulletin No. 51, Consolidated Financial Statements, Ac- counting Principles Board Opinion No. 11, Accounting for Income Taxes, the American Accounting Association's En- tity Theory of Consolidated Statements, and the SEC's Accounting Series Re- lease No. 52, dealing with the presentation of consolidated taxes on individual company statements, either do not deal with the consolidated return or do not deal with the accounting issues raised by tax figures that arise from the allocation of the consolidated tax. Even more surprising is the lack of attention paid to the consolidated tax return by the academic community. Accounting and basic tax texts give virtually no space to the consolidated return. Advanced tax texts and some journals do discuss the consolidated return, but the discussion is concerned with how to minimize taxes [Wojdak and Crumbley, 1969, pp. 173-175]. The consolidated return provisions' theoretical merit, particularly the merit of the allocation methods, almost is never discussed, nor is the proper relationship between the allocations and tax figures reported in the member's separate financial statements.

IMPORTANCE OF THE ISSUE

This inattention to the consolidated return may have been acceptable in the 1940's and 1950's when only a few thousand corporate groups faced the problem of allocating a consolidated tax liability. However, during the 1960's and 1970's, the tax law was changed so that it became progressively more ad- vantageous for eligible corporate groups to file consolidated rather than separate returns. These changes are reflected in the statistics on consolidated returns. In 1961, 24,054 corporations filed 4,553 consolidated returns which included 13 percent of all 1961 corporate net income



Weber 181

[U.S. Internal Revenue Service, 1964, pp. 34, 256]. By 1970, the last year for which statistics presently are available, 117,457 corporations filed 19,871 consolidated returns, including $37 billion of net income, or 44 percent of the year's corporate net income [U.S. Internal Revenue Service, 1974, pp. 142, 200]. The most important of these changes is the elimination of multiple surtax exemptions which became fully effective at the end of 1975. Since the changes causing this trend to consolidated returns continued through 1975, it appears certain that the consolidated return election will become increasingly more important.

The increase in numbers of consolidated returns has been accompanied by an increase in controversy surrounding the allocation of consolidated tax liabilities. Allocations have been challenged legally by regulatory agencies [Federal Power Commission, 1967], minority shareholders [Case, 1965] and creditors of subsidiaries [1974 Annual Report . . . . pp. 23-24]. In addition, a subsidiary appears to have successfully challenged an allocation (Levitt & Sons. . . , 1975). This controversy and the increased sta- tistical importance of consolidated returns require a response from the accounting community regarding the allocation of consolidated tax liabilities; otherw-se, the allocation methods for financial reporting will be shaped by the courts based on considerations other than accounting theory.

THE NEEDED RESPONSE

This paper demonstrated that using dual allocation systems may cause the reporting of misleading tax figures and

that the allocation of consolidated tax liabilities presents financial accountants with difficult reporting problems. The unacceptability of tax allocation methods for financial reporting purposes was demonstrated through a hypothetical illustration; a better allocation method was proposed; and, further, the paper pointed out the controversy surrounding these allocations.

The accounting community needs to gather information on and to examine the issues raised by the allocation of consolidated tax liabilities. The allocation methods currently in use should be sur- veyed and the frequency of their use catalogued. This information would sup- ply the basis for an informed debate, from which criteria for judging the acceptability of proposed allocation methods for financial reporting might be developed. Ideally, a single, theoretically defensible allocation formula would be prescribed for financial reporting. This method then might be incorporated into the tax law. If a single allocation formula acceptable for both tax and financial reporting purposes cannot be developed, at least the growing disparity between good accounting practice and tax law could be slowed or arrested as a result of this inquiry and debate. In addition to formulating allocation standards and methods, the accounting community must take an official position regarding the acceptability of dual allocation systems. Specifically, if the use of different allocation methods for tax and accounting purposes is acceptable, limits on these differences must be defined. If different methods are not acceptable, the practice of using them should be prohibited explicitly.

(Appendix follows on next page)




APPENDIX

ALLOCATIONS OF CONSOLIDATED TAXABLE INCOME

|START| 1

\ /

COMPUTE THE "1552 COMPUTE THE ' 1502 COMPUTE THE COMPUTE THE SEPARATE RETURN SEPARATE RETURN 1552 SEPA- CONSOLIDATED TAXABLE INCOME" TAX" UNDER Reg. RATE RETURN TAX LIABILITY UNDER Reg. 1. 1552- 1. 1502-33(d) TAX" UNDER

L 1(a)(1)(;;) t I i (2)(;) * X L I~~~~(a)(2)(ii) * I II

\V/ HAS CODE METHOD NO CODE METHOD I

2EORBECTED? ALLOCATE THE CONSOLIDATED TAX LIABILITY IN PROPORTION TO POSITIVE 1552 SEPARATE TAXABLE INCOME A

YES GO tGTO

_______________________________ _

. .NEX T PA G E HAS CODE METHOD 3 NO CODE METHOD 2 _ 5 BEEN ELECTED? ALLOCATE THE CONSOLIDATED TAX

LIABILITY IN PROPORTION TO POSITIVE 1552 SEPARATE RETURN TAX

/YES

CODE METHOD 3

_ IS THE TOTAL CONSOLIDATED TAX LIABILITY LESS THAN THE SUM OF THE 1552 SEPARATE RETURN TAX FOR ALL MEMBERS?* *

NO YES

EACH MEMBER'S ALLOCATED TAX IS ALLOCATE THE CONSOLIDATED ITS 1552 SEPARATE RETURN TAX LIABILITY UNDER CODE METHOD I TAX PLUS A SHARE OF THE EXCESS OF THE CONSOLIDATED TAX LIABILITY OVER THE SUM OF ALL MEMBERS' 1552 SEPARATE RETURN TAXES. FOR EACH MEMBER SUBTRACT ITS THIS EXCESS IS TO BE DISTRIBUTED 1552 SEPARATE RETURN UNDER CODE METHOD 1 TAX FROM ITS ALLOCATED TAX

IS THE DIFFERENCE POSITIVE T

THFOR ANY MEMBERE

I v I l~~~~~~~~lTSM THE POSITIVE DIFFERENCESI 1GO TO k ,2AND ALLOCATE THE TOTAL TO1

NEXT PAGE I IMEMBER(S) WITH NEGATIVE DIF-I 1ERENCES, IN PROPORTION TO1

|THOSE DIFFERENCESI



Weber 183

A PPENDIx (CONT.)

COMING FROM PRECEDING PAGE

IFS AN ELECTION TO MODIFY THE SECTION 1552 NO AOT ALLOCATION OF THE CONSOLIDATED TAX LIABILITY ALSTOP IN EFFECTIO

YETS

HAS MODIFICAT I ONE MEMBEEN ELECTED? | GO TO E ~~~~~~NEXT PAGE

YES

REGULATIONS MODIFICATION ONE

COMPUTE THE TOTAL 1502 SEPARATE RETURN TAX FOR ALL YEARS FOR WHICH THIS MODIFICATION IS ELECTED A

IS THE TOTAL CONSOLIDATED TAX LIABILITY, SUMMED OVER ALL YEARS FOR WHICH ELECTION IS IN EFFECT, LESS THANES F THE 1502 SEPARATE RETURN TAXEMBS AFOR THE PERIOD OF ANHE ELECTION?**

YES NO

FOR EACH MEMBER SUBTRACT ISREGARD THE FIRST ALLOCATION ITS 1502 SEPARATE OF THE CURRENT YEAR'S TAX RETURN TAX FOR THE PERIOD LIABILITY. ALLOCATE ENOUGH OF FROM THE TOTAL TAX ALLOCATED TO THE CURRENT YEAR'S TAX LIABILI- THAT MEMBER DURING THE PERIOD TYTO EACH MEMBER TO MAKE ITS OF ELECTION ALLOCATED TAX FOR THE ELECTION

PERIOD EQUAL TO THE SUM OF ITS 1502 SEPARATE RETURN

\ / _ ~~~~~~TAX LIABILITIES FOR THE SAME DOES AT LEAST ONE MEMBER PERIOD HAVE A NEGATIVE DIFFERENCE AND ONE HAVE A POSITIVE NO DIFFERENCE'!?

ALLOCATE ANY UNDISTRIBUTED YES CONSOLIDATED TAX LIABILITY

> / ~~~~~~UNDER CODE METHOD 1, 2 OR 3, ADD) THE AMOUNT OF THE NEGATIVE WHICHEVER HAS BEEN ELECTED DIFFERENCES TO THE ALLOCATIONS_ OF THE MEMBERS THAT HAVE THEM V AND SUM THE NEGATIVE DIFFERENCES |

AND DISTRIBUTE THEM AS ALLOCATION > TOP | REDUCTIONS TO THE MEMBER(S) WITH WA POSITIVE DIFFERENCES IN PROPORTION TO THOSE DIFFERENCES




APPENDIX (CONT.)

FROM PRECEDING PAGE

REGULATIONS MODIFICATION TWO

FORt EACH MEMBER SUBTRACT ITS 1552 SEPARATE

RETURN TAX LIABILITY FROM THE TAX ALLOCATED TO IT PREVIOUSLY

X / NO DOES ANY MEMBER HAVE A NEGATIVE DIFFERENCE IN

THE PRECEDING STEP?

\ / ~YES

FOR EACH MEMBER WITH A NEGATIVE DIFFERENCE IN THE PRECEDING STEP, MULTIPLY THAT DIFFERENCE BY A CONSTANT FRACTION BETWEEN 0 AND 1 (1 FOR THIS RESEARCH) AND ADD THE RESULT TO THE TAX ALREADY ALLOCATED TO THE MEMBER

SUM ALL THE AMOUNTS ADDED IN THE PRECEDING STEP AND ALLOCATE THEM AS REDUCTIONS TO THE MEMBERS WHOSE DE DUCTIONS CAUSED THESE DIFFERENCES

*1552 separate return taxable income is essentially the positive taxable income of any member, but it reflects all adjustments and limitations made on consolidation. 1552 separate return tax is the tax on the member's 1552 separate return taxable income. The 1502 separate return tax is essentially the tax that the affiliate would have paid if it had filed a separate return as a member of an affiliated group.

* *The total of all the member's separate return taxes for any given year or years may not equal the consolidated tax for the same period. However, the total tax allocated (including positive and negative allocations) must equal the consolidated tax for the period.



Weber 185

REFERENCES

American Institute of Certified Public Accountants, Accounting Principles Board, "Accounting for In- come Taxes," Accounting Principles Board Opinion No. 11 (1967).

, "Basic Concepts and Accounting Principles Underlying Financial Statements of Business Enter- prises," Statement of the Accounting Principles Board No. 4 (1970)

, "The Equity Method of Accounting for Investments in Common Stock," Accounting Principles Board Opinion No. 18 (1971).

--- , Committee on Accounting Procedure, "Consolidated Financial Statements," Accounting Re- search Bulletin No. 51 (1959).

Federal Power Commission v. United Gas Pipe Line Companly, U.S. Supreme Court, 386 US 237, 18 LE 18, 87 SC' 1003 (1967).

Case, Gertrude E., v. Newv York Central Railroad Company, 15 N. Y. 2d 150, 204 N.E. 2d 643, 256 N. Y.S. 2d 607 (Court of Appeals of New York 1965).

Crumbley, D. L., "Factors in Choosing a Method of Allocating Tax Advantages For Affiliates," Journal of Taxation, Volume 30 (June 1969), pp. 344-347.

"Levitt & Sons to Get Cash From ITT Equal to Tax Credits Due It," Wall Street Journal (12 November 1975), p. 1.

Moonitz, M., The Entity Theoryv of Consolidated Statements (Foundation Press, Inc., 1951). U.S. Internal Revenue Service, Statistics of Income . . . 1961-62 (U.S. Government Printing Office, 1964).

, Statistics of Income-1970 Corporation Income Tax Returns (U.S. Government Printing Office, 1974).

U.S. Securities and Exchange Commission, Accounting Series Release No. 52-Presentation in Financial Statements of Federal Income and Excess Profits Taxes in Cases Where a Companyv For Which Individual Statements are Filed Pals Its Tax as a Member of a Consolidated Group of Companies, 11 F.R. 10932 (10 May 1945).

Wheeler, J. E. and W. H. Galliart, An Appraisal of Interperiod Income Tax Allocation (Financial Execu- tives Research Foundation, 1974).

1974 Annual Report of the Norfolk and Western Raildway' Companv. Wojdak, J. F. and D. L. Crumbley, "Introducing Important Tax Provisions into Advanced Accounting,"

THE ACCOUNTING REVIEW (January 1969), pp. 173-175.



Documents

Misleading Tax Figures-A Problem for Accountants