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January 28, 2014

2014-Issue 4“It will never be perfect.” “Creating an effective tax sharing agreement is not a task for the timid.” “It will take on a life of its own.” “It is an evolving exercise.” “It may come to haunt you.”

These are not my words but rather the words of tax VPs with whom I have spoken about the tribulations of creating tax sharing agreements (TSAs). This article is the first of several on this subject. In this first article, we explore concepts and issues that need to be considered when creating such a document. Subsequent articles will explore:

1)     Best practices for implementing a TSA and managing all responsibilities, implied and explicit;
2)     Understanding which events often “trigger” TSA disputes; and
3)     Considerations for a TSA dispute team, both internal and external.

The Basics

What is a TSA and when is it needed? While these questions are simple ones, the fact that very often TSAs are not created betrays the notion that these agreements are simple.

A TSA is a contractual agreement often created to “spell out” the economic expectations among members of a related group of corporations included in consolidated or combined reporting tax returns. It is used to describe the instances when one member of the related group can expect to owe or to receive economic consequences for its tax items that are generated and used in consolidated or combined returns. The TSA attempts to calculate and allocate the tax consequences attributable to a specific member or group that are reported in a consolidated return.

While the need for a TSA exists any time two or more corporations are consolidated or combined into a single tax filing, the reality is that for unregulated industries, many times written agreements are created only on the eve of an expected separation of one or more members of a group, especially when such separation is brought about by a spin-off or similar corporate reorganization. Upon separation, management usually desires to adequately assess the intercompany tax accounts and contingencies of the departing member. It can often be a source of value and cash for the former affiliated group of the separated member.

Those of us who have direct experience with tax sharing agreements can attest that these contracts seem to fall somewhere on the following continuum. 


In addition, a TSA can either be imposed unilaterally by the parent or it can be a negotiated contract. Combining these two attributes results in the following 2 by 2 matrix:



In this author’s experience, TSAs that are created in anticipation of a spin-off are generally of the lengthy variety (quadrants 2 & 3), whereas those used in regulated industry settings are often much more brief. Most TSAs are unilaterally imposed by the parent. In those instances where the agreements can be said to result from genuine negotiations, the result is often a very detailed contract with exhibits that demonstrate how various clauses are expected to work given hypothetical facts. But regardless of which quadrant best describes the TSA, controversy can still be anticipated, given the inability to foresee every situation.

Perhaps an example might help facilitate the rest of our discussion:


Assume that a consolidated group consists of Parent and Subsidiary 1, Subsidiary 2 and Subsidiary 3. Assume that the following separate company income for Year 2012 is attributable to these members:


On a consolidated basis, this group has a net U.S. tax liability of $1,950. As well, no tax attributes, such as net operating losses (NOLs) or foreign tax credit carryovers to previous or subsequent years, are generated at this consolidated level. But it is also easily seen that had each of these subsidiaries been required to file separate U.S. tax returns, Subsidiary 1 would have had a “stand-alone” net tax of $3,400, and Subsidiary 2 would have a stand-alone NOL to carryback or forward of $1,000. Subsidiary 3 would have both a stand-alone NOL and a foreign tax credit carryback or forward of $2,000 and $400, respectively.

The consolidated group used, in 2012, all of the attributes that Subsidiary 2 and 3 would have been only able to use separately at a later time and against tax liabilities in other years.

The purpose of the TSA in this example would be generally to:

1) Charge Subsidiary 1 for the use of attributes of other members that the group used to reduce the stand-alone liability of Subsidiary 1 ($1,450, as calculated below); and
2) Credit Subsidiary 2 and 3 for the attributes that they separately generated but that will not be available to either of these subsidiaries in subsequent years ($350 for Subsidiary 2 (loss of $1,000 x 35% = $350) and $1,100 for Subsidiary 3 (loss of $2,000 x 35% = $700 + FTC $400 = $1,100)).

If corporate arrangements were so simple, this article would come to a close at this point. But corporate relationships are almost always more complex, and many complicating factors need to be considered in order to customize an agreement to fit the needs of the parties.

Complicating Factors

The rest of this article will identify many of the complications that often arise when creating a TSA aligned with the parties’ intent and goals and to fit the circumstances at hand.

1) Precision versus practicality: At the outset, when developing a broad outline of a TSA, a fundamental reality has to be addressed. The issue is to what degree is precision to be sacrificed in a quest for practicality? Given unlimited time and resources, one could strive to create a TSA that attempts to compute with precision the amount of tax liabilities and attributes of the various members of a TSA. Unlimited time and resources are a luxury seldom found in today’s corporate tax departments. So it is quite common to see conventions introduced into a TSA that attempt to strike an acceptable balance between precision and practicality. The most common are:

a. Effective date: Even though a member may have been a member of a consolidated group for quite some time, it is common to see an arbitrary starting point selected to peg the period over which the TSA will apply. This generally has the effect of creating an arbitrary starting date before which the entities are deemed to have a zero balance in their intercompany tax accounts or even deemed not to exist. (Intercompany “tax accounts” may not exist separately from the general intercompany accounts. In this situation, then the portion of the general intercompany accounts related to historical tax entries may need to be calculated, estimated or deemed to be a specified value.) A variant of this approach is to use an effective date with a stated opening balance of the intercompany tax account that approximates what the parties believe the intercompany tax account might be if it were computed with precision.

b. Accounting methods and conventions: To compute the impact of a TSA, it is important to compute the hypothetical stand-alone tax liability of each party to the TSA just as was done in the earlier example in this article. Consideration should be given to either explicitly expressing the specific tax accounting methods and conventions that must be used, or simply specifying that whatever methods and conventions are used in each year covered by the TSA must also be used in computing the stand-alone tax liability. So for example, if research expenses are deducted as incurred on the actual consolidated return, they might also be required to be deducted on any hypothetical stand-alone return.

c. Restricting elections: As can be seen in the example, there is no consolidated NOL, yet two of the subsidiaries have stand-alone NOLs. One of these subsidiaries has a foreign tax credit. Simplifying matters (if that is the desire of the authors of the TSA) could be accomplished by requiring that in the event a stand-alone NOL occurs, the carryback period is deemed relinquished or that no subsidiary can make a theoretical election to deduct foreign taxes rather than claiming a credit. Similarly, if bonus depreciation was not elected in the actual consolidated return, or if the alternative research credit calculation regime was elected in the actual consolidated return, both of these actual elections might dictate what elections must be used on the stand-alone return.

d. Deficiency interest: Any interest expense or refund resulting from a final governmental tax audit might be deemed to be an unallocated item. Recognizing the reality that in some instances the final tax treatment of any item in a consolidated return may be subject to trade-offs, offsets and negotiations, it might be preferable to simply consider the parent as the “funding bank” and allow it to retain all interest refunds (and absorb any interest deficiencies) without any allocation to consolidated members. Alternatively, interest may be allocated to the members but the TSA may prescribe a particular methodology or may simply state that it shall be allocated in an equitable manner.

A reality that often isn’t directly addressed is how changes in tax law are to be handled. Events covered by the TSA can take place years after the TSA is entered into. It may be one of the unspoken conditions that should a change occur, and if it can have a material difference in TSA calculations, then the parties are left to argue what is in their best interests.

2) Definition of a tax attribute: Referring to the example in this article, it may be simple to recognize what a tax attribute is. Net operating losses, foreign tax credits, minimum tax credits, capital losses and charitable contributions are some obvious candidates, to name a few. But there may be others. For example, consider sourcing and gross receipts:

a. Sourcing: Foreign tax credits are subject to a myriad of calculation mechanics, many of which either enable or limit utilization. Does one member of the group provide a foreign income source that benefits another member of the group? If one member’s income source enables the group to utilize credits, is such a member entitled to compensation?

b. Gross receipts: In the example presented above, there is no research & development credit. Is that because no entity had any research expenditures, or is it because one member of the group had such a high level of gross receipts that the group taken as a whole was ineligible to claim any credit? If one member’s level of gross receipts inhibits the group from being able to claim a research credit, should such a member be charged for that impact?

We acknowledge that expanding the definition of tax attributes to include items that might have beneficial or harmful effects on various parties to a TSA complicates the operation of the agreement. But ignoring these items might not be appropriate if their impact is deemed material.

3) Deemed use of attributes: In the example presented in this article, the use of attributes is apparent. But change the facts slightly and things become less clear. For example, assume that Subsidiary 1 had $3,500 of foreign tax credits instead of just $100. On a stand-alone basis, it would have been able to reduce its separate tax liability to zero without any use of the losses or credits of other members of the consolidated group. It is only by operation of tax law that the group is required to first use the losses of Subsidiaries 2 and 3 before any credits are actually used. Is it fair then to reward Subsidiaries 2 and 3 for the use of their attributes when such use actually causes another member of the group to place some of its foreign tax credits in a carryover position? Consider as well that under these types of hypothetical calculations, it is possible that these credits could expire without being used.

For these reasons, it is reasonable to expect the TSA to describe circumstances when attributes are deemed not used. In such an instance, it is also possible (though not necessary) to find some form of a tracking mechanism to eventually credit Subsidiaries 2 and 3 when the group finally realizes some benefit of the tax attributes “displaced” by the required use of other attributes — NOLs in this example.

4) True-up, indemnity and reimbursement provisions: Generally, the application and effect of the TSA survives the reorganization that may have caused the TSA to be entered into in the first place. This is because the parent wants to be assured of being able to economically charge the departing member for any tax costs that might arise out of settlements of pre-separation tax years’ audits. It will also want to be able to have an effective mechanism to ensure that the departing member acts in a manner that doesn’t jeopardize any tax-free rulings that might have been procured for the reorganization event. The departing member also wants to be able to true-up the intercompany accounts at the date of separation, as the final actual tax reporting of the year of separation occurs months after the actual separation date. Generally all parties want this account balance to eventually be computed with actual data and not estimates.

5) Responsibilities and administration: Prior to any corporate separation, the parent is almost always responsible for the preparation of consolidated or combined tax returns, selection of accounting methods, management of tax audits, etc. But once a reorganization takes place, the parent usually relinquishes control over the management of the affairs of some of its former members. However, because of the mechanics of carrybacks, TSA reimbursement or true-up provisions, the parent will typically have a vested interest in the continuing tax reporting and management of its former subsidiaries. Similarly, the departing members begin their independent existence, yet settlement of prior years’ tax matters may directly impact the eventual outcome of the final balance in the intercompany tax accounts as of any separation date.

Continued cooperation is essential to manage the final outcome of the eventual closing of accounts and obligations. But disputes are frequent, partly because of the inability to foresee actual events, the impact of simplifying assumptions included in the TSA, and the effects of the mere passage of time. Therefore, the dispute resolution mechanics that are often provided in the TSA (e.g., the required use of arbitration, named mediators or “referees” and access to information, etc.) must be given serious consideration.

Alvarez & Marsal Taxand Says:

It is understandable that most organizations devise TSAs only when they are needed for specific purposes, such as a reorganization or for other regulatory purposes. Creating an effective agreement is a difficult task and is something that should not be totally outsourced. An internal champion needs to be designated — hopefully someone who will be around in the five-plus years after any separation event who will need to live with the consequences of the TSA, but also be available to advise on “what the parties intended.”

In addition, in drafting TSAs, both the appropriate precision and practicality desired by its members should be given serious consideration. Such agreements should be flexible enough so that amendments can be incorporated and have effective dispute resolution provisions. 


Layne Albert, Managing Director, contributed to this article.

For More Information:

Layne Albert
Managing Director, New York
+1 212 763 9655

Sean Menendez
Managing Director, Miami
+1 305 704 6688

Brian Pedersen
Managing Director, Seattle
+1 206 664 8911

Mark Young
Managing Director, Houston
+1 713 221 3932

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