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Tax Accounting Services

Tax considerations relating to fair value accounting

Background

Fair value accounting continues to be a challenging and complex area.  The determination of fair value generally relies on a variety of assumptions and significant judgment.  Assets and liabilities measured at fair value are often significant and investors seek timely and transparent information about how fair value is measured, its impact on the financial statements and its potential to impact future periods.

Elements of fair value accounting have been embedded for decades in US Generally Accepted Accounting Principles (US GAAP).  Although the growth of fair value accounting has been incremental, its application has accelerated in recent years as a means of enhancing financial statement quality, transparency, and relevance even as the debate over its usefulness to users continues.  There are numerous accounting areas that require or permit fair value measurements.  The fair value measurements respectively affect other areas of accounting, including income taxes.

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have worked together over the last decade on converging global accounting standards.  On May 12, 2011, the FASB issued Accounting Standards Update No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in US GAAP and IFRS (ASU 2011-04), and the IASB issued IFRS 13, Fair Value Measurement (IFRS 13).  While not completely converged, this guidance significantly aligns the guidance for measuring and disclosing fair value measurements under US GAAP and International Financial Reporting Standards (IFRS).

To assist organizations in identifying and managing the tax considerations associated with fair value accounting, PwC has refreshed our Fair Value Accounting:  Tax Considerations publication (originally released in December 2008).  This publication, along with the 2012 editions of the PwC Guide to Accounting for Income Taxesand the PwC Guide to Accounting for Fair Value Measurements: Incorporating ASU 2011-04(both available through CFOdirect), highlights key insights and provides guidance for organizations.

Fair value accounting is not limited to financial assets or financial businesses.  It can apply to any business, and with respect to a wide variety of assets, liabilities and activities including:

This publication highlights what fair value accounting can mean for those responsible for organizational tax matters.  It addresses the trend from the perspective of each of several diverse areas in which tax matters intersect with fair value measurement.  The importance of coordination around these topics on a fully integrated basis, across company management functions, is underscored.

Effects of tax considerations on fair value measurements

Income taxes

Income tax considerations can have a direct effect on the use of the income (or discounted cash flows) valuation approach for fair value measurements used in financial accounting.  For example, tax amortization benefits, which are the cash flows expected from tax depreciation or amortization deductions, 1) are generally included in the assigned value of an asset acquired in a business combination and 2) may be considered when performing tests for impairment under ASC 350 Intangibles—Goodwill and Other and ASC 360 Property, Plant, and Equipment.  Tax benefits associated with assumed liabilities are likewise to be considered.

Fair value measurement should reflect tax amortization benefits irrespective of whether the particular owner acquired the asset in a manner that provides amortizable tax basis, or whether the owner is a tax paying entity, and regardless of an owner's loss or credit carryforwards.  That is, the benefits are included from the viewpoint of a neutral "market participant" (or third party).  Consideration may similarly be given to tax planning strategies that would typically be available to a market participant.

At the same time, however, the tax benefits should reflect the tax laws of the jurisdiction(s) that applies to the assets or liabilities.  If there are no tax benefits possible (in any circumstance) under the relevant jurisdiction's tax laws, the fair value measurement should not include tax benefits.  When the relevant tax laws provide for tax benefits, the timing and amount of tax benefit cash flow should be considered.

It is also important to consider that the tax laws governing purchase price allocations in taxable business acquisitions or in certain asset exchanges may not follow applicable book principles.  There may be different valuation approaches or models that are permitted or required under the tax laws.  In addition, for financial reporting purposes, goodwill impairment testing is performed on a reporting unit basis which typically reflects an assignment of assets and liabilities across legal entities.

Other taxes

An assessment of potential fair value measurement may be needed for contingencies relating to taxes that are not based on income (e.g., sales and use, property, gross receipts, value-added tax, duties and excise taxes).

ASC 805, Business Combinations, requires fair value measurement for certain acquired contingencies if the fair value can be determined during the measurement period.  In the event that the acquisition date fair value cannot be determined during the measurement period, the asset or liability should be recognized at the acquisition date in accordance with ASC 450, Contingencies, if the following criteria are met:

If the above criteria are not met using information that is available during the measurement period about facts and circumstances that existed as of the acquisition date, the acquirer should not recognize an asset or liability at the acquisition date.

Additionally, disclosure is required as to the nature of recognized contingencies and, if not measured at fair value, the reason that fair value could not be reasonably estimated.

Tax personnel should be sufficiently engaged to identify and analyze the relevant tax laws applicable to valuations and purchase price allocations.  This includes consideration of income tax rates that would be expected to apply to recover an asset or settle a liability as well as an assessment of acquired non-income-based tax exposures.  A timely and thorough analysis of such tax matters will reduce the likelihood that reported financial statements will need to be revised.

Effects of fair value measurements on cash taxes

The tax consequences of fair value measurements may be significant in jurisdictions that have net worth taxes instead of, or in addition to, income tax.  For example, some state and local jurisdictions in the US have taxes based on net worth or equity, including certain franchise taxes for the privilege of doing business in the jurisdiction.  There are also foreign jurisdictions that have hybrid tax systems under which the tax payable is based on a measurement of net income or net assets, whichever produces more tax revenue.  To the extent such taxes are based upon capital value or financial statement shareholders' equity, fair value measurements will directly impact cash taxes payable.  When paid outside the US, the creditability of such taxes may also have an indirect impact on cash taxes.

Even within an income tax system, particular items of income or deduction may be affected by fair value accounting measurements.  For example, US federal tax law permits dealers in securities and/or commodities to mark-to-market their assets using fair values reported in eligible financial statements.

Effects of fair value accounting on income tax accounting

The US GAAP and IFRS accounting for income tax standards (ASC 740 and IAS 12, respectively) currently require a "balance sheet" approach to recognizing and measuring deferred income taxes.  The book carrying amounts of assets and liabilities reported on a balance sheet are compared with their tax bases and the resulting differences, with limited exceptions, are considered taxable or deductible temporary differences.  To the extent that fair value measurements impact book carrying amounts, the measurements thereby affect the calculation of temporary differences and recognition of deferred taxes.

Volatilities in the US and global capital markets have made fair value measurements all the more significant to accounting for income taxes.  Consider, for example, the ASC 320, Investments - Debt and Equity Securities, requirements.  The standard requires certain equity and debt securities with readily determinable fair values be marked-to-market periodically, with an offsetting entry to income (for securities classified as trading), or to other comprehensive income (OCI) (for securities classified as available-for-sale).  Periodic adjustments to the book carrying amount of a security without corresponding adjustments to the security's tax basis affect temporary differences and deferred taxes.  During periods of volatility in market pricings, the impact on deferred taxes can be magnified.

Market volatility in some cases can even have a significant impact on the enterprise's effective tax rate.  Consider an available-for-sale, marketable debt security that has suffered other-than-temporary impairment (OTTI) in value because of the issuer's credit risk.  Under the current standard, although OTTI is recognized in income, it may not be deductible on a tax return until the unrealized loss is realized through a sale, liquidation, or other disposition.  In that case, it would create a deductible temporary difference and a deferred tax asset that must be assessed for realization. T o the extent the asset requires a valuation allowance (or, in IFRS accounts, cannot be recognized), there will generally be an impact on the effective tax rate.

With that said, organizations should be aware that as part of the FASB and IASB's joint Financial Instruments project, the FASB during redeliberations, changed its view with respect to assessing the realizability of deferred tax assets for unrealized losses on debt investments measured at fair value recognized in OCI.  Under this newly proposed approach, an entity would perform an assessment of the need for a valuation allowance related to such deferred tax assets (e.g., those deferred tax assets related to unrealized losses on debt investments recognized in OCI), separately from its assessment of all other deferred tax assets.  If this latest proposal is adopted, the impact on the effective tax rate would be removed for a company that asserts its ability and intent to hold such investments to maturity.

Consider, also, an equity security that had previously appreciated in value.  The unrealized book gain represents a taxable temporary difference for which a deferred tax liability was recognized.  If the value of that security "flips" to below its tax basis (e.g., original cost), the unrealized book loss represents a deductible temporary difference for which a deferred tax asset is recognized, subject to a valuation allowance assessment.  If the deferred tax liability that previously existed was a source of income that supported a conclusion that a valuation allowance was not necessary, the reversal in value has a dual impact: it removes a potential source of income and it increases the total deferred tax assets potentially requiring a valuation allowance.

Similar consequences may arise, for example, with respect to a financial institution that has elected under ASC 825-10-25 to apply the fair value option to measuring its own debt obligations.  Likewise, pursuant to ASC 825-10-25, an entity may elect to fair value an investment that has been accounted for under the equity method of accounting.  In each of these (and many other similar) circumstances, fair value measurements will affect deferred taxes.  A decline in the value of an issuer's debt would result in a deferred tax liability that could support deferred tax assets related to other items; whereas, a decline in the value of an equity method investment could precipitate the need for a valuation allowance.

Furthermore, ASC 805 created the potential for greater earnings volatility in connection with, and following, an acquisition. This standard places greater emphasis on fair value accounting and in differentiating acquisition accounting from accounting for acquirer-specific and post-acquisition events.  Fair value measurement objectives include accounting for deal costs and restructuring charges as costs outside the business combination and the recording of acquired in-process research and development, replacement stock options, certain contingencies and earn-outs at fair value.  Consequently, increased volatility may occur both in pretax earnings and in effective tax rates.

With respect to share-based compensation, ASC 718, Compensation - Stock Compensation, requires the recording of anticipated future tax benefits relating to various awards that are recorded using a fair-value-based method as they vest.  Prior to fair value share-based compensation accounting, tax benefits generally would have had impact only on shareholders' equity.  As a result of fair value pre-tax accounting, impacts on the effective tax rate will vary depending on the nature of the transactions.  At the same time, however, one aspect of share-based compensation deferred tax accounting is especially worth noting in relation to current market conditions.  That is the principle under US GAAP that respective deferred tax assets are not to be re-measured or derecognized based on the increase or decline in the fair value of the award.  Notably, this principle differs from IFRS wherein tax benefits are generally reported (or re-measured) based on the fair value of the stock at each reporting date.  Under IFRS deferred taxes are adjusted over the life of the award based upon increases or decreases in the fair value of the stock.

Effects of fair value accounting on tax planning

Fair value accounting can have tax strategy and planning implications.  In business acquisitions under ASC 805 for example, in-process research and development (IPRD) will be capitalized at fair value.  As a result, subsequent taxable transfers or cost sharing related to those IPRD projects may need to be analyzed with reference to such fair values.  Consider also the tax consequences of cost-sharing agreements for intangible property where there may be differences in the valuation methodologies used for financial reporting and income tax purposes.

Organizations should assess and document any departures from such reported values for transfer pricing purposes.  Fair value measurements will also be applied to acquired liabilities and contingencies and to contingent purchase price arrangements.  It is important to assess and differentiate any associated tax implications of those matters.  For example, tax personnel should consider whether liabilities have been assumed (thereby creating additional tax basis goodwill) in a taxable acquisition, rather than being subsequently accrued (and currently deductible) for tax purposes.

Tax planning for compensatory share-based award programs needs to be approached with care so that effective tax rate benefits are sufficiently certain.  This includes emphasis on compliance with various tax qualification rules for domestic awards programs, as well as establishment of effective cross-border chargeback arrangements to support tax benefits available outside the US.

On an overall basis, the use of fair value measurements may affect debt-equity ratios and other financial metrics.  These metrics may have tax impacts in areas such as inter-company pricing and inter-company debt.  The implications of those ratios and metrics on transfer pricing and interest deductibility can vary across tax jurisdictions.

Fair value accounting can also apply to an organization that indemnifies another organization's tax obligations.  Tax indemnifications might arise in a sale of a business, a spin-off, a joint venture, or similar transactions.  When the indemnifying party (or guarantor) is not legally obligated (under the tax law) to pay taxes covered by an indemnification agreement, ASC 460 Guarantees, may apply to require the guarantor to recognize a liability for the fair value of the guarantee at inception.

It is important for an organization's tax personnel to understand, both on a detailed and broader basis, the potential impact of fair value accounting on tax planning and structuring.  Consideration may need to be given to the effects on previously established tax plans, as well as on anticipated planning and budgeting of effective tax rates.  As for indemnifications, an organization's tax personnel should be working together with legal counsel as well as those involved with corporate development or transactional planning.

Conclusion

Tax management can, and should, play a significant role in assessing the various dimensions of fair value accounting.  It is important for tax management to be closely involved in the consideration of pretax accounting analyses, fair value accounting measurements, due diligence for transactions, and the cash and tax planning implications of fair value accounting.  Through appropriate coordination across a company, financial statement disclosures should be carefully considered and aligned with an organization's disclosed business risks and relevant pretax accounting policies.  The continued movement towards fair value accounting brings with it a variety of implications best managed through appropriate coordination across the organization.

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PwC is committed to helping companies navigate today's tax accounting issues.  Our national and global network of specialized tax accounting resources can help you tackle a wide range of tax accounting needs.  With that in mind, please visit www.pwc.com/us/tas to view our comprehensive library of tax accounting thought leadership, webcasts, and tools addressing the business and technical issues related to tax accounting.

For more information, please reach out to your local PwC partner and/or the primary authors.


Edward Abahoonie

Tax Accounting Services Technical Leader
Phone: (973) 236-4448
Email: edward.abahoonie@us.pwc.com


Steven Schaefer

Partner, National Office
Phone: (585) 231-6129
Email: steven.schaefer@us.pwc.com


Kristin Dunner
Director, US Tax Accounting Services
Phone: (617) 530-4482
Email: kristin.n.dunner@us.pwc.com

The contribution of Yosef Barbut, Director, to the original edition of this publication is gratefully acknowledged.

PwC's Global Tax Accounting Services leadership:


Ken Kuykendall
Global Tax Accounting Services
Phone: (312) 298-2546
Email: o.k.kuykendall@us.pwc.com