APB 23 Summary: Indefinite Reversal Explained

Accounting Principles Board (APB) Opinion No. 23 was an accounting standard that provided guidance on income taxes related to the undistributed earnings of subsidiaries. The standard introduced an exception to the general rule of comprehensive tax allocation for these earnings, which was relevant when their treatment differed for financial reporting versus tax returns.

The APB was the main accounting standard-setter in the U.S. before being succeeded by the Financial Accounting Standards Board (FASB). The principles from APB 23 were carried forward into the current U.S. Generally Accepted Accounting Principles (GAAP). These concepts are now located within Accounting Standards Codification (ASC) Topic 740, “Income Taxes.”

The Indefinite Reversal Criterion

At the heart of APB 23 was the “indefinite reversal criterion,” an exception to the standard practice of comprehensive tax allocation. Normally, when a parent company includes a subsidiary’s earnings in its consolidated financial statements, it must also record the future tax liability that would arise when those earnings are eventually distributed to the parent. This is because such distributions, often in the form of dividends, are taxable events.

The indefinite reversal criterion offered a way to overcome this presumption. If a company could provide sufficient evidence that the undistributed earnings of a subsidiary were to be reinvested for an indefinite period, it was not required to recognize a deferred tax liability on those earnings. The assertion allowed companies to avoid recording a current tax expense for future repatriation taxes, which could enhance reported earnings.

In this context, “indefinite” meant that there was no foreseeable plan or intention to remit the earnings from the subsidiary to the parent. It did not mean the earnings would never be distributed, but rather that management had specific plans to reinvest those funds into the subsidiary’s operations. Examples include expanding facilities, funding research and development, or acquiring other businesses, which required a clear, demonstrable plan.

This was in direct contrast to situations where earnings were expected to be remitted. If a company planned to have a subsidiary pay dividends in the foreseeable future, it could not apply the exception. In those cases, the company was required to accrue the estimated income taxes on those undistributed earnings, reflecting the future cash outflow needed to settle the tax obligation.

Scope and Application of the Exception

Foreign Subsidiaries

The most common application of the APB 23 exception was for the undistributed earnings of foreign subsidiaries. U.S.-based multinational corporations could avoid recognizing U.S. income taxes on the profits earned and held by their foreign affiliates. This was particularly advantageous because, prior to major tax law changes, the U.S. taxed its corporations on their worldwide income but generally allowed deferral of tax on foreign subsidiary earnings until they were repatriated. By asserting indefinite reinvestment, companies could treat these earnings as if they were permanently part of the foreign operations.

Domestic Subsidiaries

The exception was also available for domestic subsidiaries, but its application was much narrower and depended on specific provisions within the tax code. A deferred tax liability was not required if the tax law provided a way for the parent to recover its investment in the subsidiary tax-free. For example, certain types of corporate liquidations or reorganizations could be structured to be non-taxable events. If a company could assert its intention to utilize such a tax-free method, it could avoid recording a deferred tax liability on the subsidiary’s undistributed earnings.

Corporate Joint Ventures

The principles of APB 23 were extended to investments in corporate joint ventures that were accounted for using the equity method. If the joint venture was considered to be “essentially permanent in duration,” the investing company could apply the indefinite reversal criterion to its share of the venture’s undistributed earnings. However, for joint ventures with a limited life, it was presumed that earnings would eventually be distributed in a taxable transaction, making the exception inapplicable.

Other Special Areas

APB 23 originally addressed two other specific industries. It applied to the bad debt reserves of savings and loan associations, allowing them to avoid recognizing deferred taxes on portions of these reserves that were not expected to reverse in the foreseeable future. A similar principle was applied to the “policyholders’ surplus” of stock life insurance companies, where taxes were deferred on surplus amounts as long as they were not distributed to shareholders. These were specific applications reflecting the tax laws governing those industries at the time.

Required Documentation and Disclosures

To utilize the indefinite reversal exception, a company had to substantiate its assertion with robust evidence, which was a focal point for auditors who needed to be convinced the plans were concrete. Evidence to support an indefinite reinvestment assertion often included detailed financial forecasts and budgets for the subsidiary, showing how the retained earnings would be used to finance operational growth or capital expenditures.

Minutes from board of directors’ meetings were also a form of proof, as resolutions approving long-term expansion plans could demonstrate intent. Historical patterns of reinvestment could support the assertion, but they were not sufficient on their own.

Beyond the internal documentation, companies were subject to specific financial statement disclosure requirements. A company asserting indefinite reversal had to disclose this accounting policy in the notes to its financial statements. A key disclosure was the cumulative amount of undistributed earnings for which the parent company had not recognized income taxes. This gave investors and analysts insight into the potential tax liability that was not recorded on the balance sheet.

If determining the exact amount of the unrecognized deferred tax liability was not practicable, the company had to disclose that fact. However, regulators often challenged impracticability assertions, pushing for companies to provide a reasonable estimate of the potential tax impact.

Transition and Modern Relevance under ASC 740

The indefinite reversal exception was fundamentally altered by a sweeping change in U.S. tax law. The Tax Cuts and Jobs Act of 2017 (TCJA) represented a significant overhaul of the U.S. tax code, and it had a major impact on the APB 23 exception. The TCJA shifted the U.S. from a worldwide tax system to a territorial or participation exemption system. Under the new system, most dividends received from foreign subsidiaries are exempt from U.S. taxation.

To manage the transition, the TCJA introduced a one-time mandatory tax on all post-1986 accumulated foreign earnings that had not yet been taxed by the U.S. This tax was applied at a reduced rate—15.5% for earnings held in cash and 8% for non-cash assets—and was payable over eight years. This provision effectively eliminated the primary benefit of the indefinite reversal exception for historical foreign earnings, as these profits were now deemed repatriated and taxed, regardless of a company’s reinvestment plans.

Despite this major change, the indefinite reversal concept is not entirely obsolete. The exception can still be applied in certain circumstances. For example, it remains relevant for taxes on distributions that are not exempted by the new system, such as foreign withholding taxes or state and local income taxes. A company can use the indefinite reinvestment assertion to avoid accruing these taxes. The exception can also still apply to basis differences in investments in subsidiaries that are expected to reverse in a taxable transaction upon sale or liquidation.