Chapter 10:
Business Combinations
Chapter Summary
Business combinations can give rise to a variety of complicated issues in accounting for income taxes under ASC 740. Income tax considerations can also have a significant impact on the structure of and accounting for business combinations. In 2007, the FASB issued guidance that significantly changed the accounting for business combinations and transactions with noncontrolling shareholders. This guidance became effective for fiscal years beginning on or after December 15, 2008. This chapter discusses income tax accounting and related topics in a business combination under that guidance. Further information regarding the accounting for business combinations and accounting for transactions with noncontrolling interests can be found in the PwC publication A Global Guide to Accounting for Business Combinations and Noncontrolling Interests.
10.1 Overview
Under ASC 805, Business Combinations, an acquirer should recognize and measure deferred taxes arising from the assets acquired and liabilities assumed in a business combination in accordance with ASC 740. The acquirer should account for the potential tax effects of an acquiree’s temporary differences, carryforwards, and income tax uncertainties that exist at the acquisition date, or that arise as a result of the acquisition (ASC 805-740-25-2 and ASC 805-740-30-1).
This chapter is structured to follow the process that would typically be completed in analyzing the income tax implications of a business combination. The following highlights the steps in that process that are generally performed:
Determine the tax structure of the transaction and tax status of the entities involved in the business combination. Determine the legal structure and the tax status of the entities acquired (e.g., corporate entities, partnerships, limited liability corporations), and determine the tax structure of the transaction (i.e., taxable or nontaxable). In a taxable transaction, the tax bases of the assets acquired and liabilities assumed generally are adjusted to fair value based on the rules of the specific tax jurisdiction. In a nontaxable transaction, the historical tax bases of the assets and liabilities, net operating losses, and other tax attributes of the target generally carryover to the acquirer. See further discussion of the differences in the two structures in Section TX 10.2.
Determine financial statement and tax bases of the net assets acquired. Determine the financial statement reported amounts (i.e., book bases) of the identifiable assets acquired and liabilities assumed. ASC 805 requires the acquired net assets to be recorded at fair value, with certain exceptions. This chapter uses fair value as a general term to describe the financial reporting bases, determined as prescribed under ASC 805. The tax bases of the identifiable assets acquired and liabilities assumed are determined based on each specific tax jurisdiction and related tax laws and regulations. See Section TX 10.3 for further discussion.
Identify and measure temporary differences. Identify the temporary differences related to the book bases and tax bases of the acquired identifiable assets and assumed liabilities. Determine whether the temporary differences are deductible temporary differences or taxable temporary differences, and recognize the appropriate deferred tax assets (DTAs) or deferred tax liabilities (DTLs) (ASC 805-740-25-2). See Section TX 10.4 for further discussion of the evaluation of DTAs in a business combination.
Identify acquired tax benefits. Determine whether there are any acquired net operating losses (NOLs), credit carryforwards, or other relevant tax attributes that should be recorded as part of the business combination (ASC 805-740-25-2). Determine whether a valuation allowance is required to reduce DTAs if they are not considered to be realizable. See Section TX 10.5 for further discussion of the evaluation of DTAs in a business combination.
Consider the treatment of tax uncertainties and indemnifications. Identify and determine the accounting requirements for uncertain tax positions and indemnifications (ASC 805-740-25-2). See Section TX 10.6 for further discussion.
Consider deferred taxes related to goodwill. Determine whether a DTA should be recognized for temporary differences associated with tax-deductible goodwill (ASC 805-740-25-3). See Section TX 10.7 for further discussion of recognizing deferred taxes related to goodwill.
Section TX 10.8 discusses certain income tax accounting considerations of transactions with noncontrolling shareholders. In addition, a discussion of income tax accounting considerations related to stock-based compensation awards exchanged in a business combination can be found in Chapter TX 18.
10.2 Determine the Tax Structure of the Transaction and Tax Status of the Entities Involved in the Business Combination
The legal structure and tax status of the entities acquired and the tax structure of the transaction should be considered to determine the appropriate deferred tax balances to record in acquisition accounting. Additionally, the tax rules of the various tax jurisdictions should be considered.
10.2.1 Determining Whether the Business Combination Is Taxable or Nontaxable
The tax laws in most jurisdictions generally differentiate between taxable and nontaxable business combinations. The distinction is important, because the type of transaction determines the tax bases of the acquired assets and assumed liabilities. The acquisition of a business through the direct purchase of its assets and assumption of its liabilities (an “asset acquisition”) generally is treated as a “taxable” transaction, while the acquisition of a business through the purchase of its corporate shares (a “share” or “stock” acquisition) generally is treated as a “nontaxable” transaction. However, in some jurisdictions, a stock acquisition can be treated as an asset acquisition for tax purposes if the appropriate tax election is made and approved by the relevant taxing authorities.
10.2.2 Identifying the Tax Status of the Entities Involved
Business combinations may involve the acquisition of taxable entities (e.g., corporations), non-taxable entities (e.g., partnerships and multi-member LLCs), or a combination of both. The acquired entity’s tax status will determine the deferred tax assets and liabilities to be recorded in acquisition accounting.
When the acquiree is a corporation, the acquirer generally recognizes deferred taxes on each of the acquiree’s identifiable assets and liabilities, including tax carryforwards and credits (referred to as “inside basis differences”). When the acquiree is a partnership, however, the acquirer generally recognizes deferred taxes only for differences between the financial statement carrying amount of the acquirer’s investment and its tax basis (referred to as “outside basis differences”). This is the case regardless of whether the partnership is accounted for as a consolidated entity or as an investment for financial reporting purposes.
Sometimes a portion of the outside basis difference in a partnership acquiree is attributable to assets for which deferred taxes generally would not be recognized if the acquiree was a corporation (e.g., nondeductible goodwill and the partnership’s investment in foreign subsidiaries). In these situations, an entity should choose and consistently apply a policy to either (i) look through the outside basis of the partnership and exclude from the computation of deferred taxes basis differences arising from items for which there is a recognition exception under ASC 740, or (ii) not look through the outside basis of the partnership and record deferred taxes based on the entire difference between the financial reporting and tax bases of its investment. Refer to Section TX 11.1.9 for a more detailed discussion on partnerships and other flow-through entities.
The remainder of this chapter assumes the acquisition of a taxable entity, such as a corporation.
10.3 Determine Financial Statement and Tax Bases of the Net Assets Acquired
The recognized tax bases (the amount that is attributable for tax purposes) of the assets and liabilities are compared to the financial reporting values of the acquired assets and assumed liabilities (book bases) to determine the appropriate temporary differences (ASC 805-740-25-3). Tax laws differ by jurisdiction; therefore, each tax jurisdiction should be evaluated separately to determine the appropriate tax bases of the acquired assets and assumed liabilities.
10.3.1 Determining Tax Bases in a Taxable Transaction
In a taxable transaction (e.g., an asset acquisition or a stock acquisition treated as an asset acquisition), the acquirer records the tax bases of the assets acquired and liabilities assumed at their fair values based on the applicable tax law. The allocation methodology for determining tax bases is often similar to the requirements of ASC 805. Sometimes the acquisition price exceeds the fair value of identifiable assets acquired and liabilities assumed. The excess often is treated as goodwill for tax purposes, and may be tax-deductible. However, there could be differences in the allocation methodology because the tax allocation follows the relevant local jurisdiction tax law. For example, the U.S. federal tax code requires a specific allocation method to determine the new tax bases in a taxable transaction. The allocation methodologies for book and tax purposes may differ in cases where the aggregate fair value of the net assets acquired exceeds the consideration transferred, because bargain purchases may not be recognized for tax purposes in some jurisdictions.
Differences between assigned values for financial reporting and tax purposes should be analyzed. Regulatory bodies in various jurisdictions could question differences in the allocation of values for book and tax purposes. An inaccurate determination of fair value for tax purposes could impact the financial statements. For example, an improper tax valuation between amortizable intangible assets and goodwill could result in inaccurate deferred taxes being recorded for those jurisdictions where goodwill is not deductible.
10.3.2 Determining Tax Bases in a Nontaxable Transaction
In a nontaxable transaction (e.g., stock acquisitions), the historical tax bases of the acquired assets and assumed liabilities, net operating losses, and other tax attributes of the acquiree generally carry over from the acquired company. No new tax goodwill is created. However, tax goodwill of the acquiree that arose in a previous acquisition may carryover and will need to be considered in determining temporary differences (see Section TX 10.7.1).
10.4 Identify and Measure Temporary Differences
The acquirer should identify and measure the deductible and taxable temporary differences of the acquired business and record the resulting deferred tax assets and liabilities. The acquirer should consider applicable tax law when measuring both temporary differences and the related deferred tax assets and liabilities.
10.4.1 Basic Methodology for Recognition of Deferred Taxes on Acquired Temporary Differences and Tax Benefits
Recognition of deferred tax assets and liabilities is required for substantially all temporary differences and acquired tax loss carryforwards and credits. Exceptions include (i) temporary differences for nondeductible goodwill, and (ii) the acquired basis difference between the parent’s carrying amount of the subsidiary’s net assets (or investment) in the financial statements and its basis in the shares of the subsidiary (also referred to as the outside basis difference) (ASC 805-740-25-3).
The exception for nondeductible goodwill does not extend to identifiable intangible assets with an indefinite life. These assets may seem similar to goodwill, but are significantly different in their nature because, unlike goodwill, they do not represent residual values. Therefore, differences between the book bases and tax bases of all acquired identifiable intangible assets are temporary differences for which deferred taxes should be provided.
Example 10-1 provides an example for recognizing and measuring deferred taxes.
Example 10-1: Recording Deferred Taxes on Acquired Temporary Differences
Background/Facts:
Company Z acquires Company X in a stock acquisition (nontaxable transaction) for total consideration of $1,000. The fair value of the acquired identifiable net assets was $800. The carryover historical tax bases of the acquired net identifiable assets was $500. The tax rate is 40 percent in this jurisdiction.
Analysis/Conclusion:
Company Z recorded the following journal entries in acquisition accounting:
1 Goodwill is calculated as the residual after recording the identifiable net assets acquired and associated deferred tax assets and liabilities ($1,000 – ($800 – $120)).
2 The net deferred tax liability is calculated as the difference between the book bases (in this case, the fair value) of the identifiable net assets acquired and the carryover tax bases at the applicable tax rate
(($800 – $500) x 40%).
U.S. GAAP requires that identified assets and liabilities be presented gross and separate from the related deferred tax balances. However, a net-of-tax valuation approach based on projected after-tax cash flows is used for leveraged leases. The income tax accounting guidance for leveraged leases is found in ASC 840.
10.4.2 Expected Manner of Recovery or Settlement
A temporary difference is the difference between the carrying amount of an asset or liability in the statement of financial position and its tax basis. It will result in taxable or deductible amounts in future years when the reported amount of the asset is recovered or the liability is settled. The tax basis of an asset or liability is the amount used or attributed to the asset or liability under the tax law (ASC 740-10-25-50). In measuring a temporary difference, tax basis is the amount recognized and measured in accordance with ASC 740 (i.e., after taking into account uncertain tax positions), which may not always be the tax basis claimed on a tax return.
The carrying amount of an asset will generally be recovered through use, sale, or both. The tax consequences of using an asset or settling a liability, are sometimes different from selling net assets and may directly affect the tax that would be payable in the future. There may be different tax rates for regular income and capital gain income. Assets may sometimes be revalued or indexed to inflation for tax purposes only if the asset is sold (i.e., the tax basis is increased for the purpose of determining capital gain income but not regular income). Moreover, the ability to file consolidated, combined, or unitary tax returns, and elections or post-acquisition transactions may affect the tax that would be payable from the recovery of an asset. In some jurisdictions, recovery of assets through use will have no tax consequences, while recovery through sale will have tax consequences. The expected manner of recovery needs to be considered to determine the future tax consequences and corresponding deferred taxes in acquisition accounting.
Refer to Section TX 3.2.2 for further discussion of the impact of indexing for tax purposes on the calculation of deferred taxes; section TX 8.6.3 for further discussion of the accounting for a change in tax status as part of a business combination.
10.4.3 Deferred Taxes Related to Outside Basis Differences
A business combination may include the acquisition of certain temporary differences for which ASC 740 provides an exception for recording deferred taxes. For example, the tax basis in shares of certain entities may differ from the financial reporting basis (i.e., the outside basis difference). No deferred tax liability is required for the outside basis difference if the parent can establish the intent and ability to indefinitely delay reversal of the difference. This exception applies only to foreign subsidiaries and foreign corporate joint ventures (that are essentially permanent in duration). For domestic subsidiaries, if the parent has the intent and can demonstrate an ability to eliminate the outside basis difference in a tax-free manner, then no deferred tax liability is required to be recorded (ASC 740-10-25-3, ASC 740-30-25-7).
A company meets the indefinite reversal criteria if it can assert the intent and ability to indefinitely reinvest earnings abroad and not repatriate the earnings (ASC 740-30-25-17). The determination of whether deferred taxes related to the outside basis differences should be recorded at the acquisition date is based on the acquirer’s intent regarding the acquired investments. For example, if the acquirer intends to repatriate earnings from the acquired entity and cause a reversal of the outside basis difference, then a deferred tax liability should be recognized in acquisition accounting. This is true even if the acquiree had previously not recorded deferred taxes on its outside basis differences.
The impact of the acquirer’s intent related to assets already owned by the acquirer should be evaluated separately from the acquirer’s intent related to assets acquired. The effect of a change in the assertion related to an acquirer’s intent and ability to indefinitely delay the reversal of temporary differences related to subsidiaries it owned prior to acquisition is recorded outside of acquisition accounting. The tax effect of a change in assertion related to current year activity (e.g., current year foreign currency translation) is recorded in the same financial statement element (i.e., income statement, OCI) as the pretax activity. The tax effect of the change related to prior years’ activity (including effects derived from foreign currency translation) is recorded in the income statement, because backwards tracing1 is not allowed under ASC 740 for these types of items (ASC 740-30-25-19, ASC 740-20-45-3).
1 U.S. GAAP requires the allocation of income tax expense or benefit to elements of the financial statements (e.g., income statement, equity). Most subsequent changes in deferred taxes are recorded in income tax expense from continuing operations and are not “backward traced” to the original element affected (ASC 740-20-45-3).
The outside tax basis of an investment may exceed the book basis. ASC 740 prohibits the recognition of a deferred tax asset for an investment in a subsidiary or corporate joint venture that is essentially permanent in duration unless the temporary difference is expected to reverse in the foreseeable future (ASC 740-30-25-9).
Example 10-2 illustrates the application of deferred tax accounting recognition and measurement to an acquired outside taxable basis difference.
Example 10-2: Deferred Tax Accounting Related to Acquired Outside Basis Difference when an IRC Section 304 Restructuring Transaction is Implemented Following a Business Combination
Background/Facts:
Parent, a U.S.-based multinational, acquired all of the shares of Target, another U.S.-based multinational, in a nontaxable transaction. Both U.S. companies have a Dutch holding company through which they own several lower-tier foreign subsidiaries. In conjunction with the acquisition, Parent intends to consolidate the respective businesses and achieve operational, process and tax efficiencies by restructuring the ownership of Target’s Dutch holding company. Under the restructuring plan, Parent’s Dutch holding company (Dutch Co. A) will buy from Target all of the shares of Target’s Dutch holding company (Dutch Co. B). The two Dutch companies will form a parent-subsidiary consolidated tax return group in the Netherlands. Parent has historically maintained an indefinite reinvestment assertion and, thus, has not recorded a U.S. DTL for the outside basis difference related to its investment in Dutch Co. A. Parent also intends to similarly defer the U.S. tax consequences (i.e., assert indefinite reinvestment) with respect to the acquired basis difference (in Dutch Co. B) beyond any amount that will reverse in the restructuring. The following table summarizes the relevant book and tax bases immediately before the restructuring:
To implement the restructuring, Dutch Co. A paid $3,000 in exchange for all of the shares of Dutch Co. B. For U.S. federal tax purposes, the transaction is subject to IRC section 304. Under that Code section, if one corporation purchases stock of a related corporation in exchange for property, the transaction generally is recharacterized as a redemption that produces a dividend. In this case, the dividends are taxable to the extent of the accumulated earnings and profits (E&P) of the two Dutch companies ($9,000), subject to the following ordering rule: Dutch Co A’s E&P is considered first; if the value of the distribution exceeds its E&P, the excess is considered to be paid from Dutch Co B’s E&P. If either corporation has foreign source income that has already been taxed under the IRC subpart F rules (referred to as “previously taxed income” or PTI), the distribution is considered to be made first from PTI (distribution of PTI) and is taxable only to extent of unrecognized foreign exchange gains or losses).
Analysis/Conclusion:
In this example, the first $2,000 is considered to be a distribution of PTI from Dutch Co. A, taxable only to the extent of any foreign exchange gain; the remaining $1,000 is considered to be a fully taxable dividend distribution from Dutch Co. A’s E&P. Therefore, the tax effect should be recorded outside of acquisition accounting. The tax impact related to a Parent’s outside basis it already owns should be accounted for outside of acquisition accounting and the following journal entry would be recorded:
1 CU1,000 fully taxable distribution x 35% (applicable U.S. tax rate) = CU350 (For simplicity, assume no foreign tax credits are claimed for this taxable distribution and that there are no unrecognized currency exchange gains or losses related to PTI).
Assuming the same facts in the illustration above except that Dutch Co. A has no accumulated E&P. In this circumstance, the first CU2,000 is considered to come from Dutch Co. A’s PTI and the remaining CU1,000 is considered to come from Dutch Co. B’s accumulated E&P. The tax impact related to an acquired outside basis difference should be recorded in acquisition accounting and the following journal entry would be recorded:
2 CU1,000 fully taxable distribution x 35% (applicable U.S. tax rate) = CU350 (For simplicity, assume no foreign tax credits are claimed for this taxable distribution and that there are no unrecognized currency exchange gains or losses related to PTI).
3 When the distribution occurs, the acquired deferred tax liability would be reversed and a current tax liability would be recognized.
In measuring deferred taxes for acquired assets and liabilities, Parent would consider the expected method of recovery or settlement and, when applicable, its intent and ability to avoid or trigger tax consequences on acquired outside basis differences. The tax impact of Parent’s intention related to an outside basis difference it already owned should be accounted for apart from the acquisition, whereas the tax impact of Parent’s intention related to an acquired outside basis difference should be recorded in acquisition accounting.
Parent’s intent related to the $2,000 acquired outside basis difference is to defer the tax consequences for the foreseeable future and therefore no DTL is recognized in acquisition accounting. Alternatively, if the IRC 304 restructuring had resulted in some portion (or all) of the acquired outside basis difference in Dutch Co. B reversing, the tax effects related to that reversal would be recorded in acquisition accounting consistent with Parent’s expectation as to the manner in which the acquired outside basis difference is expected to be recovered.
10.4.4 Recording the Tax Effect of Contingencies and Contingent Consideration in Business Combinations
Acquisition accounting under ASC 805 includes the recognition of acquired contingent assets or assumed contingent liabilities and contingent consideration, all of which affect the amount of book goodwill recorded at the acquisition date (ASC 805-20-25-19, ASC 805-30-25-5).
However, these items generally are not recognized for tax purposes until the amounts are fixed and reasonably determinable or, in some jurisdictions, until they are paid. These conditions often are not met until a future financial statement period. As a result, these items would not have tax basis on the acquisition date. In a taxable transaction, the tax basis in the newly created goodwill does not include an incremental amount related to these contingencies (there is no tax-deductible goodwill created in a nontaxable transaction). Therefore, the difference in treatment for these items could give rise to temporary differences for which deferred taxes should be recognized at the date of acquisition and adjusted in subsequent periods as the contingency or contingent consideration is adjusted for financial reporting purposes.
A temporary difference for which deferred taxes should be recorded generally exists if the resolution of the contingency or contingent consideration will result in a future tax consequence (i.e., deduction or income) (ASC 740-10-25-20). The tax consequence upon resolution of the contingency or contingent consideration is affected by whether the business combination was a taxable or nontaxable transaction. For example, the resolution of a contingent liability in a nontaxable transaction may result in a tax deduction, in which case a deferred tax asset should be recorded on the acquisition date. In a taxable transaction, the resolution of a contingent liability may affect the amount of tax-deductible goodwill, in which case the exceptions to recognition of deferred taxes related to goodwill at the acquisition date may need to be considered (see Section TX 10.7).
If the resolution of the contingency or contingent consideration will increase or decrease the amount of tax-deductible goodwill, an acquirer may take one of two acceptable approaches to account for the related deferred taxes.
One approach is to consider the impact on tax-deductible goodwill in the initial comparison to book goodwill as if the contingent liability or contingent consideration was settled at its book basis at the acquisition date. This approach is explored in more detail in this section.
Another approach is to treat the contingency or contingent consideration as a separately deductible item. A deferred tax asset would be recorded in acquisition accounting because the liability, when settled, will result in a future tax deduction (i.e., tax-deductible goodwill). That is, a deferred tax asset is recognized at the acquisition date since there is a basis difference between book and tax related to the liability without regard to the impact it would have on the comparison of tax-deductible goodwill to book goodwill. The deferred tax asset would be calculated by multiplying the temporary difference by the applicable tax rate. The second approach ignores the initial comparison of book goodwill to tax-deductible goodwill for this particular component even though the liability will be added to tax-deductible goodwill when settled.
The approach adopted is an accounting policy choice and should be applied consistently for all acquisitions.
The following table summarizes the deferred tax accounting associated with the most common scenarios for contingencies and contingent consideration in a taxable transaction, using the first approach described above, and in a nontaxable transaction. Further discussion and examples are included in Sections TX 10.4.4.1 (taxable transaction) and TX 10.4.4.2 (nontaxable transaction).
See TX 10.6 for a discussion about the effects of income tax uncertainties.
10.4.4.1 Contingencies and Contingent Consideration—Taxable Transactions
In a taxable business combination, the settlement of a contingency or contingent consideration will often impact the ultimate amount of tax-deductible goodwill. Following the approach of determining deferred taxes by calculating the tax basis as if the contingency or contingent consideration is settled at the book basis, the recorded amount of the contingency or contingent consideration is added to the tax-deductible goodwill balance as if it were settled at the acquisition date. If the amount of that hypothetical tax-deductible goodwill (as adjusted for the contingency) exceeds the amount of book goodwill, then a deferred tax asset should be recorded. Because the deferred tax asset is related to goodwill, an iterative calculation is required to determine the amount of the deferred tax asset. However, if book goodwill exceeds the hypothetical tax goodwill, no deferred tax liability is recorded (ASC 805-740-25-9). Recording deferred taxes on goodwill is discussed further in Section TX 10.7.
Example 10-3 illustrates the described approach for determining deferred tax balances related to contingent consideration at the acquisition date in a taxable business combination.
Example 10-3: Acquisition Date Deferred Taxes Related to Contingent Consideration in a Taxable Business Combination
Background/Facts:
Assume contingent consideration is valued on the acquisition date in a taxable business combination at $1,000. Goodwill for book purposes (including the initial recording of contingent consideration) is $3,000. Tax-deductible goodwill is $1,800, which excludes the initial recording of contingent consideration. The applicable tax rate for all periods is 40 percent. When the contingent consideration is settled, it will be included in tax-deductible goodwill.
Analysis/Conclusion:
To determine deferred taxes at the acquisition date, consider the resulting tax consequence if the contingent consideration is settled for the book basis. Since the amount of contingent consideration would be added to tax-deductible goodwill when settled, the amount of contingent consideration is added to the balance of tax-deductible goodwill to determine whether there is an excess of tax or book goodwill. The goodwill balances are analyzed as follows:
If book goodwill exceeds tax-deductible goodwill, no deferred taxes are recognized. However, if the tax-deductible goodwill exceeds book goodwill, a deferred tax asset is recognized. For example, assuming the same facts as above, except that the contingent consideration was valued at $1,500 at the acquisition date, the tax-deductible goodwill (as adjusted) would have been $3,300. The excess of the tax-deductible goodwill (as adjusted) over the book goodwill of $300 would have resulted in a deferred tax asset. See Section TX 10.7.2 for a discussion of how the deferred tax asset is calculated.
This approach to measuring deferred taxes is also applicable to contingent liabilities in a taxable business combination.
Adjustments to contingencies and contingent consideration in subsequent periods that are not measurement period adjustments generally are recorded for financial reporting purposes in earnings (ASC 805-30-35-1). The appropriate deferred tax treatment related to these adjustments is determined by considering the expected tax consequence, assuming the item is settled at its book basis. Deferred taxes are adjusted if the adjustment to the contingency or contingent consideration would cause a tax consequence (e.g., increase or decrease a deductible expense or asset).
The acquisition date comparison of book goodwill to tax-deductible goodwill should not be reperformed subsequent to the acquisition date unless there is a measurement period adjustment. ASC 805 treats pretax adjustments to contingencies and contingent consideration that are not measurement period adjustments as being outside of acquisition accounting with no adjustment to book goodwill. Therefore, the tax effect of adjustments to contingencies and contingent consideration should also be reflected outside of acquisition accounting.
For example, a deferred tax asset should be recognized or adjusted along with the related income tax expense or benefit when contingent consideration is increased subsequent to the acquisition date for a change in fair value, and the settlement of the contingent consideration would increase tax-deductible goodwill. This is true even if no deferred tax asset was recorded at the date of acquisition (i.e., tax goodwill did not exceed book goodwill at the acquisition date).
Similarly, consider an example where a contingent consideration liability is decreased subsequent to the acquisition date due to a change in fair value. A decrease in the contingent consideration liability subsequent to the acquisition date causes a decrease in the tax-deductible goodwill as if the contingent consideration is settled. This decrease in the contingent consideration liability which will result in a decrease in the tax-deductible goodwill when settled will be recorded by either (i) recording a deferred tax liability (i.e., when book goodwill exceeded tax-deductible goodwill at the acquisition date), or (ii) reducing a deferred tax asset (i.e., when tax-deductible goodwill exceeded book goodwill at the acquisition date).
Example 10-4 illustrates this approach for determining deferred tax balances related to an adjustment to contingent consideration in a taxable business combination.
Example 10-4: Deferred Taxes Related to a Contingent Consideration Adjustment in a Taxable Business Combination
Background/Facts:
Assume contingent consideration is valued on the date of acquisition in a taxable business combination at $1,000 and is increased in year two to $1,700. The contingent consideration is eventually settled in year three. At the acquisition date, goodwill for book purposes (including the initial recording of contingent consideration) is $3,000. Tax-deductible goodwill is $1,800, which excludes the initial recording of contingent consideration. The applicable tax rate for all periods is 40 percent. For simplicity, the effects of amortization of tax goodwill are excluded from the example. Once the contingent consideration is settled, it will be included in tax-deductible goodwill. At the acquisition date, book goodwill of $3,000 was in excess of tax-deductible goodwill (including the expected additional basis to be recognized when settled) of $2,800; therefore, no deferred tax asset was recorded for contingent consideration. See Example 10-2 for an illustration of recording deferred taxes related to contingent consideration at the acquisition date.
Analysis/Conclusion:
In year two, the fair value of the contingent consideration increases by $700 to $1,700. The adjustment, when settled, will result in additional tax-deductible goodwill.1 Therefore, a deferred tax asset related to the adjustment should be recorded, even though no deferred tax asset related to tax-deductible goodwill was recorded at the acquisition date, because the acquisition date comparison of book to tax goodwill is not revisited under this approach.
The following entry would be recorded:
1 In some jurisdictions, a portion of the contingent consideration may be treated as tax-deductible interest. For simplicity, this example does not address that fact pattern.
2 ($700 x 40%).
There is no impact on the effective tax rate because the pretax expense related to the increase in contingent consideration has a corresponding deferred tax benefit.
The same treatment would apply if there is a decrease in the contingent consideration. For example, if the contingent consideration had decreased by $700, a deferred tax liability of $280 would have been recorded. When resolved, the adjustment to the contingent consideration would result in a decrease in tax-deductible goodwill (i.e., a decrease in a tax deduction).
Year Three:
Contingent consideration is settled at $1,700. Since the item is settled for the amount previously recorded, there is no further impact on earnings or deferred taxes. The deferred tax asset is not adjusted because the contingent consideration was settled at the recorded amount for book purposes, but has not yet been deducted for tax purposes (i.e., the deduction will occur over time as goodwill is amortized).
The following entry is recorded:
The same treatment would apply for a contingent liability in a taxable business combination.
A contingent consideration arrangement that is equity-classified is not remeasured based upon subsequent changes in fair value and the ultimate settlement is accounted for within equity (ASC 805-30-35-1).
Example 10-5 illustrates the tax accounting for equity-classified contingent consideration that is settled for more than its carrying amount.
Example 10-5: Accounting for Tax Effects from the Settlement of Equity-Classified Contingent Consideration
Background/Facts:
Assume equity-classified contingent consideration is valued on the date of acquisition in a taxable business combination at $100,000. The contingent consideration would be settled by issuing stock to the seller when certain performance metrics are met at which time the settlement value would be included in tax-deductible goodwill. Accordingly, no deferred tax is recorded for the equity-classified contingent consideration. The fair value of the contingent consideration increases by $50,000 to $150,000 in year two when it is settled for $150,000 (the fair value of the shares issued to the seller at the time of settlement).
Analysis/Conclusion:
The settlement is accounted for as a reclassification within equity at the recorded value of $100,000. However, the settlement resulted in additional tax basis in goodwill of $50,000 to be amortized (in addition to the $100,000) in future periods. The tax benefit from the additional tax basis, net of any valuation allowance if required, should be recognized in equity (ASC 740-20-45-11(g)). The guidance in ASC 740-20-45-11(g) requires that the tax effects of all changes in tax bases of assets and liabilities caused by transactions among or with shareholders be included in equity. The issuance of stock to the seller in full settlement of equity-classified contingent consideration should be regarded as a transaction with a shareholder.
10.4.4.2 Contingencies and Contingent Consideration—Nontaxable Transactions
The amount paid to settle a contingent liability assumed in a nontaxable business combination may result in a tax deduction. A deferred tax asset should be recorded in acquisition accounting for the acquired contingency if the applicable tax law(s) would allow for a deduction when the contingent liability is settled. This concept is illustrated in Example 10-6.
Example 10-6: Deferred Tax Impact of Contingent Liabilities in a Nontaxable
Business Combination
Background/Facts:
Assume a contingent liability is recorded at fair value of $1,000 on the date of acquisition in a nontaxable business combination. The tax basis in the contingent liability is zero. When the liability is settled, the company will receive a tax deduction for the amount paid. The tax rate is 40 percent.
Analysis/Conclusion:
The contingent liability is a temporary difference at the acquisition date, because it has a zero tax basis and when the liability is settled it will result in a tax deduction. The following entry would be recorded at the acquisition date:
The deferred tax asset should be adjusted in subsequent periods as the amount of the contingent liability changes.
The settlement of contingent consideration in a nontaxable business combination often will be added to the outside tax basis as part of the amount paid for the acquiree. The contingent consideration, therefore, is added to the outside tax basis for purposes of determining the difference between outside tax basis and book basis. Deferred taxes would not be affected by the contingent consideration at the acquisition date, nor upon adjustment to the amount of contingent consideration in subsequent periods, unless a company is providing deferred taxes on outside basis differences. Therefore, subsequent changes in the amount of contingent consideration could impact an entity’s effective tax rate, because it is likely that pretax effect of changes in contingent consideration would be recorded in the income statement without a corresponding tax effect. Recording deferred taxes on outside basis differences is discussed further in Section TX 10.4.3.
Example 10-7 illustrates this approach for determining deferred tax balances related to contingent consideration in a nontaxable business combination.
Example 10-7: Deferred Tax Impact of Contingent Consideration in a Nontaxable Business Combination
Background/Facts:
Assume contingent consideration is valued on the acquisition date in a nontaxable business combination at $1,000. In year two, the fair value of the contingent consideration increases by $1,200 to $2,200 and is settled for cash in year three at $2,200. The applicable tax rate for all periods is 40 percent. Once the contingent consideration is settled, for tax purposes it will be added to the basis of the shares acquired (i.e., outside basis). No deferred tax liability is recorded on the outside basis temporary difference in the shares acquired.
Analysis/Conclusion:
To determine the deferred taxes at the acquisition date, consider the resulting tax consequence if the contingent consideration is settled for its book basis. The contingent consideration, when settled, will be added to the basis of the acquired shares for tax purposes. Therefore, deferred taxes will not be recorded since the resolution of the contingent consideration will affect only the outside tax basis of the shares.
At the date of acquisition, the following entry would be recorded:
An acquirer would need to calculate the incremental tax basis as a result of the settlement of the contingent consideration if deferred taxes were being provided on the outside basis of the entity.
Year Two:
The $1,200 adjustment to fair value of the contingent consideration is recognized in earnings. However, there is no corresponding tax effect recorded at that time, because the resolution of the contingent consideration will affect only the outside tax basis of the shares, on which no deferred taxes are being recorded. In this case, adjustment of the contingent consideration will impact the effective tax rate because there is a pretax expense item without a corresponding tax effect. The effect on the rate can be demonstrated as follows (assuming income before tax and contingent consideration of $10,000 and no other permanent or temporary items):
Year Three:
Contingent consideration is settled at $2,200.
The following entry would be recorded:
In year three, there is no further impact on earnings or the effective tax rate because the contingent consideration was settled for the amount previously recorded. No deferred tax entry is required since the contingent consideration is added to the tax basis in the shares and deferred taxes are not being provided on the outside basis difference.
10.4.5 Deferred Taxes Related to Research and Development Activities
Research and development activities (R&D) acquired in a business combination will be capitalized as tangible or intangible assets based on their nature. The capitalized in-process R&D (IPR&D) activities are accounted for as indefinite-lived intangible assets, subject to impairment testing until completion or abandonment of the projects. The acquirer estimates the useful life of the asset once each project is complete (ASC 805-20-35-5).
Deferred tax liabilities related to indefinite-lived assets typically are not used as a source of income to support realization of deferred tax assets in jurisdictions where tax attributes expire (e.g., jurisdictions where net operating loss carryforwards expire) unless the deferred tax liability is expected to reverse prior to the expiration date of the tax attribute. The acquirer should determine whether the deferred tax liability related to R&D will reverse in a period that would allow realization of the deferred tax assets.
Example 10-8 illustrates the approach for considering whether a deferred tax liability for R&D activities should be considered a source of income for realizing deferred tax assets.
Example 10-8: Whether a Deferred Tax Liability for R&D Activities Should Be Considered a Source of Income for Realizing Deferred Tax Assets
Background/Facts:
Company A acquires Company B in a nontaxable business combination. Company A capitalizes an acquired R&D intangible asset for $100 and records an associated DTL of $40. Under ASC 805, the R&D intangible asset is classified as indefinite-lived until the project is either abandoned or completed, at which time a useful life will be determined. Company A plans to file a consolidated tax return with Company B. Company A had a pre-existing DTA of $30 for NOLs that will expire in 10 years (for simplicity, assume this is the Company’s only DTA). Prior to the acquisition, Company A had a valuation allowance against the DTA.
Analysis/Conclusion:
To determine whether the DTL related to the R&D intangible asset can be used as a source of taxable income to provide realization of the DTA, Company A must assess the expected period of completion of the R&D project and the expected useful life of the related intangible asset representing the resulting intellectual property once the project is complete. If Company A expects the project to be completed within two years and expects the useful life of the intangible asset to be three years, then the DTL should be used as a source of income in assessing the realization of the DTA because the DTL is expected to reverse (over years three to five) before the NOL carryforward expires. If Company A reverses all or a portion of its valuation allowance as a result of this analysis, the benefit is recorded outside of acquisition accounting in continuing operations. Alternatively, if Company A has limited or no visibility into how long the research period may last and/or the useful life of the resulting intellectual property, then the reversal of the taxable temporary difference might not provide a source of taxable income for tax attributes with expiration periods.
10.4.6 Deferred Taxes Related to Acquisition-Related Costs
Under ASC 805, acquisition-related costs are not part of the fair value of the consideration that is transferred between the buyer and the seller. Such acquisition costs are expensed as incurred by the acquirer (ASC 805-10-25-23). However, acquisition-related costs may be treated one of several ways for tax purposes depending on the tax jurisdiction and the type of costs. For example, these costs could be expensed as incurred; capitalized as a separate intangible asset; included in the basis of the shares acquired; included in the basis of other assets; or included in tax-deductible goodwill.
If the acquisition costs are not immediately deductible for tax purposes, a potential temporary difference is created. We believe there are two acceptable alternatives for determining the appropriate deferred tax treatment for acquisition costs.
One alternative is to consider whether the acquisition costs would result in a future tax deduction if the business combination was not consummated. If so, then the acquisition costs represent a deductible temporary difference for which a deferred tax asset should be recognized when the costs are expensed for financial reporting. This approach is considered acceptable because the consummation of a business combination is generally not anticipated for accounting purposes. When the acquisition is consummated, companies will need to revisit the appropriate accounting for the temporary difference and consider whether the deferred tax asset should be reversed. Depending on how the acquisition costs are treated for tax purposes (e.g., added to the outside basis of the shares), it may no longer be appropriate to record deferred taxes on such acquisition costs. Reversal of a deferred tax asset would be reflected in the income statement and would affect the effective tax rate in the period the acquisition is consummated.
Another alternative is to consider the expected ultimate tax consequence of the costs. If the costs are expected to be included in the outside basis of the shares for tax purposes, as is typically the case in a nontaxable business combination, then, unless the company expects to record deferred taxes on the outside basis temporary difference, no deferred tax asset would be established related to the acquisition costs. Therefore, the acquisition costs would be expensed with no corresponding tax effect, which would affect the effective tax rate in the period the acquisition-related costs are expensed. If the costs are expected to be included in a tax-deductible asset (e.g., tax-deductible goodwill), then deferred taxes would be provided on the acquisition costs. This approach is considered acceptable, because it is appropriate to consider the expected tax consequence of the reversal of the temporary difference in the recognition and measurement of deferred taxes (ASC 740-10-25-20). This approach requires a continuous evaluation of expectations at each reporting date and recognition of deferred tax adjustments consistent with revised expectations.
At the acquisition date, tax-deductible goodwill is compared to book goodwill to determine whether a deferred tax asset should be recorded. Under either approach set forth above, acquisition costs would not be included in the tax goodwill amount for purposes of the comparison of tax-deductible goodwill to book goodwill, because the acquisition costs are not included in financial reporting goodwill. See Section TX 10.7 for further discussion of recording deferred taxes on goodwill.
Since these costs will not be reflected in acquisition accounting for financial reporting purposes, associated deferred taxes that are recorded or later reversed will be reflected in the income statement.
The costs to issue debt or equity securities shall be recognized in accordance with other applicable GAAP (ASC 805-10-25-23). Costs to issue debt or equity securities are not part of acquisition accounting. As such, any associated tax effect will be reflected in the income statement, or directly in equity, but not in acquisition accounting.
See Section 17.5.1 for discussion on acquisition-related transaction costs in calculating estimated annual effective tax rate.
10.4.7 Identifying the Applicable Tax Rate to Calculate Deferred Tax Assets and Liabilities
In determining deferred taxes, the identification of the applicable tax rate for each jurisdiction (and sometimes for each individual type of temporary difference) is important. The determination of the applicable tax rate should consider the effects of the business combination. This may be important in situations where graduated rates were historically significant for the business, because the combined business’s operations may require the application of a different statutory rate (ASC 740-10-30-8
through 30-9). See Section TX 10.5.6 for discussion of recording the impact of an expected change in the applicable tax rate on the acquirer’s deferred tax balances.
The applicable rate is determined based on enacted tax rates, even if the parties included apparent or expected changes in tax rates in their negotiations. ASC 740 requires that rate changes be reflected in the period when enacted. Further, a change in enacted rates subsequent to the acquisition date may result in an immediate positive or negative impact on the tax provision in the postcombination period (ASC 740-10-45-15).
Companies that file financial statements with the SEC may be required to apply push-down accounting, whereby the parent’s basis in the investment is pushed down to the legal entities acquired. Regardless of whether push-down accounting is applied, the applicable tax rate(s) used to measure deferred taxes should be determined based on the relevant rate(s) in the jurisdictions where the acquired assets are recovered and the assumed liabilities are settled, as discussed in Example 10-9.
Example 10-9: Applicable Tax Rate
Background/Facts:
A holding company acquires (in a “nontaxable” transaction) 100 percent of the shares of another business. The holding company is incorporated in a jurisdiction that does not impose income taxes, and the acquired business is in a jurisdiction where income is subject to income taxes. The holding company identifies temporary differences between the fair value (as determined under ASC 805) for financial reporting purposes and the tax bases of the individual assets acquired and liabilities assumed.
Analysis/Conclusion:
The consolidated financial statements should include deferred taxes related to the book versus tax basis differences of the acquired net assets. The deferred taxes should be measured at the enacted income tax rate(s) applicable to the acquired business. The tax rate applied should consider the jurisdiction in which the acquired assets are recovered and the assumed liabilities are settled, even if the parent’s basis in the investment has not been pushed down to the separate financial statements of the acquired business.
10.5 Identify Acquired Tax Benefits
The acquirer should determine whether there are any net operating loss, credit, or other carryforwards to record as part of acquisition accounting. The discussion in this section does not consider the fact that certain tax uncertainties could be embedded in the net operating loss, credit, or other carryforwards (ASC 805-740-25-2). Generally, a deferred tax asset is recorded in full, but is then reduced by a valuation allowance if it is more-likely-than-not that some or all of the deferred tax asset will not be realized (ASC 740-10-30-5(e)).
10.5.1 Realization Test for the Acquired Tax Benefits
The methodology for determining the realizability of deferred tax assets is based on the availability of future taxable income. Refer to Chapter TX 5 for a discussion of how to assess the realizability of deferred tax assets. A buyer would not recognize a DTA unless it is more-likely-than-not the DTA will be realized. If a DTA is recognized in acquisition accounting, it would generally result in an increase in the amount of recognized goodwill. This analysis should be done on a tax jurisdictional basis as required by ASC 740.
An acquirer that will include the acquiree in a consolidated tax return should consider the tax attributes and future taxable income of the combined business when assessing whether acquired deferred tax assets are realizable. For example, deductible differences or carryforwards of the acquiree can be realized because
(i) they may be offset by the acquirer’s tax attributes under the applicable tax laws, (ii) the acquirer has sufficient taxable temporary differences that will generate future taxable income, or (iii) the acquirer anticipates having sufficient other future taxable income to ensure realization. These new sources of future taxable income from the perspective of the combined business may make it possible to recognize deferred tax assets for the combined business at the date of acquisition.
Combined tax attributes or income may also provide evidence as to the realizability of the acquirer’s own deferred tax assets at the date of acquisition. However, changes in the assessment of realizability of the acquiring company’s deferred tax assets are not included in acquisition accounting (see Section TX 10.5.6).
10.5.2 Evaluating Future Combined Results Subsequent to the Business Combination
To determine the need for a valuation allowance at the date of acquisition, it is necessary to consider all available evidence. In jurisdictions where a consolidated tax return will be filed (i.e., acquiring and acquired business consolidated), it may be necessary to consider the expected future taxable income of the combined business.
To perform the evaluation, past results as well as expected future results should be considered. It will be necessary to adjust past results of the acquired business to reflect depreciation and amortization based on the amounts assigned in acquisition accounting. This may, at first, seem inappropriate for a business acquired in a nontaxable acquisition, because its future taxable income will be measured based on its carryover tax basis. But the objective of this analysis is to provide some indication of the future earnings power of the combined business. Temporary differences at the date of acquisition will be measured based on the differences between the carryover tax basis (in a nontaxable acquisition) and the fair values assigned in acquisition accounting. If the fair values are higher, the reversals of resulting taxable differences may themselves ensure realization of future tax benefits. Such pro forma results for the most recent prior year tend to be the most meaningful. However, results for periods more than one or two years prior to the consummation of the business combination should also be considered. Judgment will have to be applied in reviewing the available evidence and to adequately consider historical results to arrive at a meaningful outcome. See Section TX 5.3.2 for additional discussion on determining the need for a valuation allowance in a business combination.
10.5.3 Considering the Acquirer’s Taxable Differences as a Source of Realization
The acquirer’s own deferred tax liabilities may provide a source for the realization of deferred tax assets acquired in a business combination and, therefore, may be an important component in assessing the need for a valuation allowance for the deferred tax assets that arise from the acquisition. As a result, the acquirer may need to determine its temporary differences at the date of acquisition, which may be difficult if the acquisition occurs at an interim date. The acquirer’s temporary differences on the date of the acquisition should be determined in each jurisdiction and may be computed using one of the three approaches described below:
1. Assume that, as of the acquisition date, the acquirer files a short-period tax return. In some jurisdictions, the tax laws govern how annual deductions, such as depreciation, are allowed in a short-period return. The existing book bases of the assets and liabilities would then be compared with these “pro forma” tax bases to determine the temporary differences.
2. Assume that temporary differences arise evenly throughout the year. That is, if the beginning temporary difference is $100 million and the projected ending temporary difference is $220 million, the temporary difference is assumed to increase by $10 million a month as the year progresses.
3. Assume that temporary differences arise in the same pattern that pretax accounting income is earned. That is, if pretax income is earned 10, 20, 30, and 40 percent in the first through fourth quarters, respectively, then temporary differences would increase or decrease on that basis as well. That is, if the beginning temporary difference is $100 million and the projected ending temporary difference is $220 million, the expected annual increase of $120 million is assumed to occur in proportion to the pretax income (i.e., 10, 20, 30, and 40 percent in the first through fourth quarters, respectively).
The acquirer should determine the approach most suitable to its facts and circumstances.
10.5.4 Limitation of Tax Benefits by Law
In certain business combination transactions, the acquired business and its tax attributes may be integrated into the consolidated tax returns and positions of the acquirer. However, depending on the specific tax jurisdiction, there may be various limitations on the use of acquired tax benefits. Some examples of these limitations include:
Utilization of certain attributes, such as NOLs or tax credits, may be limited due to a change in corporate ownership structure or a significant change in business operations. These limitations might be expressed as an absolute amount, a formula-based limitation (e.g., annually changing percentage of the acquired tax benefit), or a relationship to taxable income (e.g., 30 percent of taxable income can be offset by acquired NOLs).
Use of acquired loss carryforwards may be limited to postacquisition taxable income of the acquired business.
The acquired business may be subject to tax in a different jurisdiction or may file a separate return in the same jurisdiction as the acquirer and, thus, use of the acquired tax benefits may be limited based on the results of the acquiree’s own operations.
All restrictions are considered in assessing whether the deferred tax assets for acquired tax benefits are recognizable or realizable (e.g., which future expected taxable income is relevant or the impact of expiration periods in case of limited annual use).
10.5.5 Changes to the Acquired Deferred Tax Assets after the Business Combination
The recoverability of deferred tax assets is reassessed at each reporting period and, if circumstances lead to the conclusion that it is more-likely-than-not that part or all of deferred tax assets will eventually be utilized, the valuation allowance recorded is reduced or eliminated (i.e., partially or fully released) (ASC 805-740-45-2).
ASC 805-740 changes the accounting for the initial recognition of acquired deferred tax assets subsequent to the acquisition date. The release of a valuation allowance that does not qualify as a measurement period adjustment is reflected in income tax expense (or as a direct adjustment to equity as required by the intraperiod allocation provisions of ASC 740) subject to the normal intraperiod allocation rules. The release of a valuation allowance within the measurement period resulting from new information about facts and circumstances that existed at the acquisition date is reflected first as an adjustment to goodwill, then as a bargain purchase (ASC 805-740-45-2).
The acquirer must consider whether changes in the acquired deferred tax balances are due to new information about facts and circumstances that existed at the acquisition date or are due to events arising in the postcombination period. Changes resulting from discrete events or circumstances that arise within the measurement period and did not exist at the acquisition date generally would not be recorded in acquisition accounting (ASC 805-10-25-13 through 25-14).
For example, the impact of a subsequent business combination occurring during the measurement period of a prior acquisition would likely not qualify as a measurement period adjustment. The subsequent business combination would typically not represent new information about facts and circumstances that existed at the acquisition date, but would rather be an event arising in the postcombination period. Therefore, if a subsequent business combination triggers the release of a valuation allowance established in a prior acquisition, such release would typically be recorded as a decrease in income tax expense. The guidance in ASC 805 related to measurement period adjustments to acquired deferred tax balances is consistent with the guidance for changes in other acquired assets and liabilities. See Chapter BCG 2 of the PwC publication A Global Guide to Accounting for Business Combinations and Noncontrolling Interests for further discussion of measurement period adjustments.
Unlike the general transition provisions of ASC 805, whereby the guidance is applied only to business combinations consummated after the effective date, the guidance related to the release of a valuation allowance subsequent to the acquisition date also applies to business combinations consummated prior to the effective date of ASC 805 (ASC 805-10-65-1(b)).
Example 10-10 illustrates the application of the measurement period guidance to a change in valuation allowance.
Example 10-10: Measurement Period Guidance Applied to a Change in Valuation Allowance
Background/Facts:
Company A acquires Company B on July 1st. Company B’s normal business activities are construction and demolition. A full valuation allowance related to Company B’s acquired deferred tax assets is recorded in acquisition accounting. A natural disaster occurs after the acquisition date, but prior to June 30th of the following year (i.e., within the measurement period). The natural disaster directly results in Company B obtaining a major new cleanup contract. The company has not provided any natural disaster cleanup services in the past and providing such services was not a factor in determining the acquisition-date value of Company B.
Analysis/Conclusion:
The increase in taxable earnings from the natural disaster cleanup contract could not be foreseen and was not part of the acquirer’s assumptions in establishing the valuation allowance at the acquisition date. Therefore, the resulting change in the valuation allowance would not be recorded as a measurement period adjustment, but rather would be recorded in earnings.
10.5.6 Changes in the Acquirer’s Deferred Tax Balances Related to Acquisition Accounting
The impact on the acquiring company’s deferred tax assets and liabilities caused by an acquisition is recorded in the acquiring company’s financial statements outside of acquisition accounting. Such impact is not a part of the fair value of the assets acquired and liabilities assumed.
For example, in jurisdictions with a graduated tax rate structure, the expected postcombination results of the company may cause a change in the tax rate expected to be applicable when the deferred tax assets and liabilities reverse. The impact on the acquiring company’s deferred tax assets and liabilities is recorded as a change in tax rates and reflected in earnings (ASC 740-10-45-15).
Additionally, the acquirer’s financial statements may have included a valuation allowance before the transaction for its deductible differences or loss carryforwards and other credits. After considering the transaction and the projected combined results and available taxable differences from the acquired business, the acquirer may be able to release all or part of its valuation allowance. While this adjustment is directly related to the consequences of the acquisition, ASC 805 requires the recognition of the benefit in income or equity, as applicable, and not as a component of acquisition accounting. Such benefit is related to the acquirer’s existing assets and should not be considered in the determination of the fair values of the assets acquired and liabilities assumed (ASC 805-740-30-3).
Similarly, if a valuation allowance is required by the acquirer as an indirect result of the acquisition, this immediate charge should be reflected in the income statement at the date of the acquisition. The concept is similar to the one discussed above, such that these tax charges are specific to the acquirer’s existing assets and should not be considered in the application of acquisition accounting.
Acquired deferred tax liabilities could be a source of income to support recognition of acquired deferred tax assets or the acquirer’s existing deferred tax assets, or both. As discussed above, only to the extent acquired deferred tax liabilities support the acquirer’s existing deferred tax assets is the effect of releasing any related valuation allowance reflected in earnings (i.e., outside of acquisition accounting). Accordingly, in circumstances in which some but not all of the combined deferred tax assets are supported by acquired deferred tax liabilities, the acquirer will need to apply an accounting policy to determine which balances are being supported. We believe there are two acceptable accounting policies: one policy is to consider the recoverability of deferred tax assets acquired in the acquisition before considering the recoverability of the acquirer’s existing deferred tax assets. Another policy is to consider relevant tax law ordering rules for utilization of tax assets to determine whether the acquired or pre-existing deferred tax assets are considered realizable.
Example 10-11 illustrates the application of the accounting policy on valuation allowance considerations in acquisition accounting.
Example 10-11: Accounting Policy for Considering Whether Acquired Deferred Tax Liabilities Support Realization of Acquired or Acquirer’s Deferred Tax Assets
Background/Facts:
Company X and Company Y each have $2,000 of DTAs related to net operating loss (NOL) carryforwards generated in the last four years. Other deferred tax assets and liabilities are de minimis. Company X has historically maintained a valuation allowance against its DTAs. In the current period, Company X acquires the stock of Company Y in a nontaxable transaction and the combined business will file a consolidated tax return. As part of the acquisition, assume DTLs of $1,500 related to Company Y are recorded and the combined entity cannot rely on future taxable income for realization of DTAs. However, the acquired DTLs will reverse prior to any NOL expirations and are, therefore, a source of future taxable income for realization of DTAs. There are no tax law limitations on future realization of the NOL carryforwards. Consequently, Company X determines it needs a valuation allowance of $2,500 (combined DTAs of $4,000 less reversing DTLs of $1,500).
Analysis/Conclusion:
Deferred taxes are recorded in acquisition accounting for the acquired entity’s temporary differences and operating loss/credit carryforwards (ASC 805-740-25-2). However, any changes in the acquirer’s deferred taxes as a result of a business combination should be recorded currently in income (ASC 805-740-30-3).
In the fact pattern described above, we believe there are two alternative methods to account for the benefit that can be recognized in Company’s X financial statements:
View A—The DTLs should first be considered as a source of taxable income in relation to the acquired company’s DTAs, with any residual amount applied to the acquirer’s DTAs. This view is premised on the sequence of events, starting with the acquisition, followed by the consideration of impacts on the acquirer. In the case above, a $500 valuation allowance would be recorded in acquisition accounting (i.e., $1,500 of the $2,000 acquired DTAs are expected to be realized), and there would be no recognition of the acquirer’s pre-existing DTAs. The valuation allowance against the acquirer’s DTAs ($2,000) would not change.
View B—Realization of DTAs should be based on underlying tax law ordering for the jurisdiction (e.g., looking first to older NOLs if that is consistent with the tax law in the relevant jurisdiction). The objective would be to determine the reversal pattern of tax attributes and tax-deductible temporary differences under the tax law. However, where the order in which tax attributes and tax-deductible temporary differences will be used is not determinable, the entity should develop a systematic, rational, and consistent methodology for allocating the benefit resulting from the DTLs.
Either view A or view B is acceptable as an accounting policy election provided the policy is applied consistently to acquisitions with appropriate financial statement disclosure, including specific disclosure of any benefits or expenses recognized for changes in the acquirer’s valuation allowance (ASC 805-740-50-1).
10.5.7 Business Combinations Achieved in Stages
An acquirer sometimes obtains control of an acquiree in which it held an equity interest prior to the acquisition date. In a business combination achieved in stages, the acquirer shall remeasure its previously held equity interest in the acquiree at its acquisition-date fair value and recognize the resulting gain or loss (i.e., the difference between its fair value and carrying value) in earnings. If changes in the fair value of the equity interest were previously recorded in other comprehensive income (OCI), the amount of unrealized gains or losses should be reclassified from OCI and included in the measurement of the gain or loss on the acquisition date (ASC 805-10-25-10). The recognition of a gain or loss at the acquisition date represents the recognition of the economic gain or loss that is present in the previously held equity interest.
Prior to obtaining control, deferred taxes would have been based on the difference between the carrying amount of the investment in the financial statements and the tax basis in the shares of the investment (i.e., outside basis difference). Unless a current tax is triggered, remeasuring the previously held equity interest to fair value will increase the book basis with no corresponding increase in the tax basis, thus changing the outside basis difference and associated deferred tax. Since the acquirer’s gain or loss from remeasuring the acquirer’s previously held investment is reflected in net income, the corresponding tax effect of the change in outside basis difference caused by such gain or loss should be reflected in the acquirer’s income tax expense from continuing operations. The gain or loss associated with a previously held equity interest might include the effects of reclassifying amounts from accumulated OCI to net income (e.g., unrealized gains or losses on AFS securities and CTA). Generally, the corresponding reclassification adjustment from OCI to net income will also include any related income tax expense or benefit that was previously recognized in OCI.
Example 10-12 illustrates the impact on the outside basis difference from remeasuring a previously held investment to fair value.
Example 10-12: Impact on Outside Basis Difference from Remeasuring a Previously Held Investment
Background/Facts:
Company A has a 20 percent equity-method investment in Company B with a carrying value of $1,000 and a tax basis of $800. Company A has recorded a corresponding deferred tax liability of $80 ($1,000 – $800 x 40%). Company A acquires the remaining 80 percent of Company B. The fair value of Company A’s previously held investment in Company B is $1,500 at the acquisition date.
Analysis/Conclusion:
Company A would remeasure its investment in Company B to $1,500 and record a gain of $500 for financial reporting purposes. Company A’s book versus tax basis difference in the previously owned shares of Company B would increase from $200 ($1,000 – $800) to $700 ($1,500 – $800) at the acquisition date. Assuming a 40 percent tax rate, Company A would record the following tax entry to increase the deferred tax liability from $80 to $280:
1 Increase in outside basis difference of $500 x 40% tax rate.
Upon obtaining control, the acquirer may no longer need to recognize deferred taxes on the outside basis of the investment due to the provisions of ASC 740 (e.g., there is a means for tax-free recovery of the investment). In this case, the accounting for the deferred tax related to the previously held investment depends on whether the subsidiary is foreign or domestic.
If the subsidiary is domestic and the parent has the intent and ability under the tax law to recover its investment in a tax-free manner, then the entire deferred tax liability related to the outside basis difference on the previously held investment is reversed. The effect of reversing the deferred tax is recorded in the acquirer’s income tax expense from continuing operations and does not impact acquisition accounting. The gain or loss associated with a previously held equity interest might include the effects of reclassifying amounts from accumulated OCI to net income (e.g., unrealized gains or losses on AFS securities and CTA). Generally, the corresponding reclassification adjustment to OCI will also include any related income tax expense or benefit that was recognized in OCI.
If the subsidiary is foreign, then generally a portion of the deferred tax liability related to the outside basis difference on the previously held investment must be retained. ASC 740 requires that a deferred tax liability continue to be recorded for the temporary difference related to the investor’s share of the undistributed earnings of a foreign investee prior to the date it becomes a subsidiary. The deferred tax liability should remain as long as dividends from the subsidiary do not exceed the parent company’s share of the subsidiary’s earnings subsequent to the date it became a subsidiary (ASC 740-30-25-16). Effectively, the deferred tax liability at the acquisition date for the outside basis temporary difference caused by undistributed earnings of the foreign investee is “frozen” until that temporary difference reverses.
Outside basis differences can arise from activities other than from undistributed earnings (e.g., currency translation adjustments). In such cases, it is unclear as to what portion of the deferred tax liability should be retained.
One view is that upon gaining control of an equity- or cost-method investee, the deferred tax liability for the entire outside basis difference, including any basis difference resulting from adjusting the investment to fair value, is frozen until that temporary difference reverses. A second view is that only the portion of the deferred tax liability that relates to undistributed earnings of the investee as of the date control is obtained is frozen. The approach selected is an accounting policy choice that should be applied consistently from acquisition to acquisition. However, in some jurisdictions, the recovery of an investment in a foreign equity investee does not have tax consequences to the investor. In such circumstances, a deferred tax liability for holding gains would not be recognized (and then frozen) when control is obtained as such gains would never be taxable and therefore do not constitute temporary differences.
Upon gaining control of the investee, the acquirer will apply acquisition accounting and recognize the assets acquired and liabilities assumed, including goodwill. The acquirer must then identify and measure associated deferred tax assets and liabilities. Consider a situation where the acquiring company obtains a step-up tax basis in the net assets acquired for the portion most recently purchased, but does not obtain a step-up tax basis for the portion previously held (i.e., carryover tax basis related to the previously held investment). The method for calculating tax bases would result in larger inside book-over-tax-basis differences as a result of the acquirer’s previously held investment, which, in turn, would impact the amount of goodwill recorded in acquisition accounting. Example 10-13 illustrates this concept.
Example 10-13: Impact on Inside Basis Differences from a Previously Held Investment
Background/Facts:
Company A has a 20 percent equity-method investment in Company B, with a carrying value of $1,000 and a tax basis of $800. Company A acquires the remaining 80 percent of Company B for $8,000 and elects, under the tax law, to obtain a step-up of the inside tax bases of the net assets acquired for the 80 percent purchased (i.e., elected to treat the transaction as taxable). The fair value of the previously held 20 percent investment at the acquisition date is $2,000.
Analysis/Conclusion:
The resulting inside tax bases would be a combination of the 20 percent carryover tax basis and the 80 percent fair value ($800 + $8,000 = $8,800).
For financial reporting, the net assets acquired are recorded at fair value (as prescribed by ASC 805). The net assets acquired, including goodwill, are recorded at $10,000.1
The book bases exceed the tax bases by $1,200 ($10,000 – $8,800). The excess is attributable to the carryover inside tax bases resulting from the 20 percent previously held investment.2 Therefore, a deferred tax liability generally would be recorded as part of acquisition accounting.3
In a taxable transaction where the acquirer did not have a prior investment in the acquiree, the inside tax bases would equal the consideration transferred at the date of acquisition. Consequently, no book and tax inside basis differences generally exist, and, therefore, no deferred taxes would be recorded on the acquisition date.
1 $2,000 fair value of 20 percent previously held investment plus $8,000 consideration transferred for the remaining 80 percent.
2 Fair value of 20 percent previously held investment less carryover tax bases ($2,000 – $800 = $1,200).
3 Consideration would need to be given to the prohibition against recording a deferred tax liability on excess book over tax-deductible goodwill (see Section TX 10.7).
Deferred taxes related to inside basis differences are recorded in acquisition accounting. Deferred taxes are one element of the acquired assets and assumed liabilities. ASC 805 requires the acquirer to recognize and measure deferred taxes arising from the net assets acquired and other temporary differences of the acquiree that exist at the acquisition date or arise as a result of the acquisition in accordance with ASC 740, ASC 805-740-25-2 and ASC 805-740-30-1. The resulting deferred taxes arise from recording the individual assets acquired and liabilities assumed in the acquisition and should therefore be recorded in acquisition accounting. The deferred taxes related to the net assets acquired would impact goodwill.
10.6 Consider the Treatment of Tax Uncertainties
The issuance of ASC 805 did not alter the guidance as it relates to the initial accounting and recording of uncertain tax positions in business combinations. In a taxable business combination, positions may be taken in allocating the acquisition price and in filing subsequent tax returns, which are expected to be challenged by the taxing authority and perhaps litigated. Similarly, in nontaxable business combinations there may be uncertainties about the tax basis of individual assets or the preacquisition tax returns of the acquired business. Both types of situations are considered to be uncertain tax positions.
10.6.1 Recording Tax Uncertainties
The recording of income-tax-related uncertainties is performed in accordance with ASC 740. ASC 740, a comprehensive two-step structured approach to accounting for an uncertainty in income taxes, provides specific guidance on recognition, measurement, and other aspects of reporting and disclosing uncertain tax positions. For a position to qualify for benefit recognition, the position must have at least a more-likely-than-not (i.e., greater than 50 percent) chance of being sustained, based on the position’s technical merits, upon challenge by the respective taxing authorities (i.e., step one). If the position does not have at least a more-likely-than-not chance of being sustained, none of the benefit associated with that tax position is recognized.
After concluding that a particular position has a more-likely-than-not chance of being sustained and, therefore, should be recognized in the financial statements (i.e., step one), a company must carry out step two. Under that step, the amount of tax benefit that can be recorded in the financial statements is determined. ASC 740 uses a measurement methodology that is based on cumulative probability, resulting in the recognition of the largest amount of tax benefit that is greater than 50 percent likely of being realized upon settlement with a taxing authority having full knowledge of all relevant information (ASC 740-10-25-6 and ASC 740-10-30-7).
The seller may provide indemnifications related to tax uncertainties to the acquirer. There is a potential inconsistency in recognizing and measuring an asset for an indemnification at fair value if the related liability is measured using a different measurement attribute, such as those discussed above related to tax uncertainties. Therefore, ASC 805 prescribes that the acquirer shall recognize an indemnification asset at the same time that it recognizes the indemnified item, measured on the same basis as the indemnified item, subject to any contractual limitations and the need for a valuation allowance for uncollectible amounts (ASC 805-20-25-27 through 25-28). At each subsequent reporting date, the acquirer shall measure an indemnification asset that was recognized at the acquisition date on the same basis as the indemnified item, subject to any contractual limitations on its amount and assessment of collectability (ASC 805-20-35-4). Caution should be exercised in measuring the amount of the indemnification arrangement because a number of indemnification arrangements do not fully cover the related tax uncertainty (e.g., in some cases both parties agree to share in the risk). The indemnification asset should be recorded as an asset, separate from the associated liability. Determining whether or not to record deferred taxes related to the indemnification asset will depend on the expected tax consequences from recovering the asset. The analysis would be similar to that used in determining the deferred tax accounting for contingent consideration as discussed in Section TX 10.4.4. See Chapter BCG 2 of the PwC publication A Global Guide to Accounting for Business Combinations and Noncontrolling Interests and Section TX 16.10 for further discussion related to indemnifications.
10.6.2 Subsequent Resolution of Tax Uncertainties in a Business Combination
Under ASC 805, adjustments to uncertain tax positions made subsequent to the acquisition date are recognized in earnings, unless they qualify as measurement period adjustments. Measurement period adjustments are recorded first as an adjustment to goodwill, then as a bargain purchase. See Section TX 10.5.5 for a discussion of evaluating whether an adjustment within the measurement period relates to circumstances that were included in the acquirer’s assessment at the date of the acquisition (ASC 805-740-45-4).
Unlike the general transition provisions of ASC 805, the guidance for recognition of adjustments to acquired income tax uncertainties also applies to existing uncertainties arising in a business combination consummated prior to the effective date of ASC 805 (ASC 805-10-65-1(b)).
10.7 Deferred Taxes Related to Goodwill
Goodwill for financial reporting purposes is a residual amount. Acquired goodwill for financial reporting purposes is capitalized as an asset and is not amortized. Some business combinations, particularly taxable business combinations, can generate goodwill that is deductible for tax purposes (also referred to as “tax-deductible goodwill”).
The amount assigned to goodwill for book and tax purposes could differ, due to different valuation and allocation rules and differences in determining the amount of consideration transferred (e.g., different treatment of contingencies or costs incurred for the transaction). ASC 740 describes the separation of goodwill into components to assist in determining the appropriate deferred tax accounting related to goodwill at the acquisition date. The first component (component-1) equals the lesser of (i) goodwill for financial reporting or (ii) tax-deductible goodwill. The second component (component-2) equals the remainder of each, that is, (i) the remainder, if any, of goodwill for financial reporting in excess of tax-deductible goodwill or (ii) the remainder, if any, of tax-deductible goodwill in excess of the goodwill for financial reporting (ASC 805-740-25-8).
The following chart displays the concept of component-1 and component-2 goodwill:
10.7.1 Excess of Tax-Deductible Goodwill over Book Goodwill
An excess of tax-deductible goodwill over goodwill for financial reporting is a temporary difference for which a deferred tax asset is recognized (ASC 805-740-25-9).
In a nontaxable transaction where the historical tax bases of the acquired business carryover to the acquirer, there may be tax-deductible goodwill from prior acquisitions of the acquiree that carries over in the current acquisition. In this instance, a question arises as to how to treat the carryover tax deductible goodwill in determining deferred taxes. In general, we believe that the carryover tax deductible goodwill should be compared to the book goodwill arising in the current transaction for purposes of determining whether a recognizable temporary difference exists (see Section TX 10.7.2).
In analyzing component-1 and component-2 goodwill, the expected impact on tax-deductible goodwill of contingent consideration and contingent liabilities should be considered. See Section TX 10.4.4 for further discussion of the relationship between the comparison of book goodwill to tax-deductible goodwill and contingent liabilities or contingent consideration. See TX 10.4.6 for further discussion of the treatment of acquisition-related costs and the comparison of book goodwill to tax-deductible goodwill.
10.7.2 Recognition of a Deferred Tax Asset for Excess Tax-Deductible Goodwill
ASC 805 prescribes the recognition of a deferred tax benefit resulting from tax-deductible goodwill that is in excess of book goodwill. The tax benefit of the excess tax goodwill is recognized as a deferred tax asset at the acquisition date, which increases the values assigned to the acquired net assets and correspondingly decreases book goodwill. This, however, further increases (i) the difference between book goodwill and tax-deductible goodwill and (ii) the corresponding deferred tax balance (ASC 805-740-55-9 through 55-13). To deal with this iterative process, the computation of the deferred tax asset can be reduced to the following equation:
(Tax Rate / (1 – Tax Rate)) x Preliminary Temporary Difference (PTD) = DTA
The resulting amount of deferred tax asset reduces book goodwill. If book goodwill is reduced to zero, any additional amounts recognized will result in a bargain purchase gain. Example 10-14 provides an example of the iterative calculation.
Example 10-14: Recording a Deferred Tax Asset for Excess Tax-deductible Goodwill, No Bargain Purchase Gain
Background/Facts:
A taxable acquisition results in initial book goodwill of $450 million. A separate determination for taxes results in tax-deductible goodwill of $600 million. The gross PTD between book and tax goodwill is $150 million. Assume an applicable tax rate of 40 percent.
Analysis/Conclusion:
The deferred tax asset for the excess tax-deductible goodwill is (in millions):
(40% / (1 – 40%)) x $150 = DTA of $100
The acquirer would record a deferred tax asset for $100 million with a corresponding decrease in book goodwill. Therefore, final goodwill for financial reporting purposes would be $350 million, and a deferred tax asset of $100 million would be established. The resulting deferred tax asset appropriately reflects the temporary difference related to goodwill, as illustrated below:
(Tax goodwill – book goodwill) x 40% = DTA
($600 – $350) x 40% = $100
Example 10-15 illustrates a situation where the formula used to determine the deferred tax asset related to excess tax-deductible goodwill requires modification.
Example 10-15: Recording a Deferred Tax Asset for Excess Tax-deductible Goodwill with Bargain Purchase Gain
Background/Facts:
A taxable acquisition results in initial book goodwill of $200 million. A separate determination for taxes results in tax-deductible goodwill of $600 million. The gross PTD between book and tax goodwill is $400 million. Assume an applicable tax rate of 40 percent.
Analysis/Conclusion:
When the initial calculation of the DTA related to goodwill exceeds the amount of book goodwill, the total DTA to be recognized will be equal to the tax effect of tax-deductible goodwill (i.e., tax-deductible goodwill less book goodwill of zero). Therefore, the company will record a DTA of $240 million (i.e., $600 million tax goodwill less $0 book goodwill x 40%). A portion of the DTA recognized in acquisition accounting will reduce initial book goodwill to zero. The remaining amount of the DTA is recorded as a bargain purchase gain. The following demonstrates the recognition of a deferred tax asset for excess tax-deductible goodwill with a bargain purchase gain based upon the facts described above.
The initial calculation of the deferred tax asset for excess tax-deductible goodwill is (in millions):
(40% / 1 – 40%) x $400 = DTA or $267
However, the DTA is in excess of book goodwill. Recording a DTA of $267 million would result in a complete elimination of the book goodwill and a tax benefit of $67 million. In that case, the DTA would not appropriately reflect the temporary difference related to goodwill, as illustrated below:
(Tax goodwill – book goodwill) x 40% = DTA
($600 – $0) x 40% = $240, which does not equal the $267 DTA as previously calculated
The following formula can be used to determine the amount of PTD required to eliminate all book goodwill:
(40% / (1 – 40%)) x PTD = $200 (book goodwill)
Solving for PTD = $300
A deferred tax asset is recorded and goodwill is adjusted to the extent of the calculated limit of PTD, calculated as follows:
(40% / 1 – 40%) x $300 = $2001
1 Recorded as a DTA and as an adjustment to goodwill.
The remaining amount of deferred tax asset is recorded as a bargain purchase gain. The following formula can be used to determine the amount of the gain:
(PTD original result – PTD revised limit) x 40% = gain
($400 – $300) x 40% = $402
2 Recorded as a DTA and as a bargain purchase gain.
The following entry would be recorded (in millions):
The resulting deferred tax asset appropriately reflects the temporary difference related to goodwill, as illustrated below:
(Tax goodwill – book goodwill) x 40% = DTA
($600 – $0) x 40% = $240
Measurement period adjustments are recorded retrospectively and, therefore, may affect goodwill (ASC 805-10-25-17). If after the measurement period adjustments, tax-deductible goodwill exceeds book goodwill, the associated deferred tax asset should be recorded or adjusted. This adjustment will be recorded against goodwill.
10.7.3 Situations in Which the Iterative Formula May Not Apply
Use of the equation described in Section TX 10.7.2 is not appropriate in every situation. Complexities may arise that require modification of the formula and, in some cases, preclude its use altogether. These complexities may include either of the following situations:
The formula uses a single statutory tax rate. However there may be situations where the temporary differences arising in the acquisition would be tax-effected at different rates (i.e., where there are different rates in a carryback period or a rate change has been enacted for future years, or where the temporary differences give rise to more than one type of taxable income). In these situations, successive calculations may be required to determine the deferred tax asset.
To the extent that a valuation allowance is required for all or part of the deductible temporary differences, there may be no or only a partial iterative effect on goodwill. Again, successive calculations may be required to determine the deferred tax asset.
10.7.4 Excess of Book Goodwill Over Tax-Deductible Goodwill
When there is an excess of book over tax goodwill, as of the acquisition date, no deferred tax liability is recorded for the excess book goodwill. Establishing a deferred tax liability would increase further the amount of goodwill, as it would decrease the value of the net assets acquired. This would, in turn, require an increase in the deferred tax liability, which would again increase goodwill, etc. As a consequence, this approach is not followed, as it would result in the grossing up of goodwill and the deferred tax liability, which the FASB determined would not add to the relevance of financial reporting. Implicit in this treatment of goodwill is an assumption that its carrying amount will be recovered on an after-tax basis.
10.7.5 Recognition of Deferred Tax Liabilities Related to Tax-Deductible Goodwill Subsequent to the Acquisition Date
In periods subsequent to the acquisition, component-2 goodwill may result in an excess of book goodwill over tax-deductible goodwill, and changes in the temporary difference for the component-2 book goodwill are disregarded; deferred taxes are provided only for differences arising between the book and tax basis of component-1 goodwill (e.g., due to amortization for tax purposes or impairment for book purposes). When component-2 goodwill is an excess of tax-deductible goodwill over book goodwill, changes in the entire temporary difference are recorded. For example, amortization of component-2 tax-deductible goodwill will reduce the corresponding deferred tax asset until the tax basis is equal to the book basis and will create a deferred tax liability for the basis difference created by tax amortization thereafter (ASC 805-740-25-9).
10.7.6 Deferred Tax Related to Tax-Deductible Goodwill and Indefinite-Lived Intangible Assets—Source of Taxable Income
A deferred tax liability related to goodwill may be created in periods subsequent to an acquisition, as described in Section TX 10.7.5. Deferred tax liabilities related to an asset with an indefinite useful life (goodwill and indefinite-lived intangible assets) in jurisdictions where there is a finite loss carryforward period will ordinarily not serve as a source of income for the realization of deferred tax assets, because the deferred tax liability will not reverse until some indefinite future period when the asset is sold or written down due to impairment. Therefore, a company may need to record a full valuation allowance on its deferred tax assets and report a net deferred tax liability. In situations where there are indefinite carryforward periods, these deferred tax liabilities would generally be considered to be a source of taxable income. This should be evaluated on a facts and circumstances basis.
10.7.7 Deferred Tax Considerations in Testing Goodwill for Impairment
Goodwill is allocated to organizational units called reporting units for financial reporting purposes, and is subject to periodic and trigger-based impairment tests. A goodwill impairment test is done in two steps. In step one, in order to identify a potential impairment, the fair value of the reporting unit is compared to its carrying value (including goodwill). If fair value is less than carrying value, step two of the test is performed to determine the amount of the goodwill impairment, if any. In step two, the implied fair value of goodwill is determined in the same manner that the amount of goodwill recognized in a business combination is determined. That is, the fair value of the reporting unit is assigned to the assets and liabilities of the unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination. If the carrying amount of goodwill exceeds the implied fair value of goodwill, an impairment loss is recognized for that excess amount (ASC 350-20). See Chapter BCG 11 of PwC’s A Global Guide to Accounting for Business Combinations and Noncontrolling Interests for further discussion of goodwill impairment.
To determine the fair value of the reporting unit during step one of the test, an assumption as to whether the reporting unit would be sold in a taxable or nontaxable transaction is made. Whether the reporting unit would be bought or sold in a taxable or nontaxable transaction is a matter of judgment that depends on the relevant facts and circumstances, and must be evaluated carefully on a case-by-case basis. See Chapter BCG 11 of PwC’s A Global Guide to Accounting for Business Combinations and Noncontrolling Interests for the things to consider when making the determination. Regardless of the assumption used, when determining the carrying value of the reporting unit, deferred tax balances that relate to the assets and liabilities of the reporting unit are included in the carrying value of the reporting unit (ASC 350-20-35-7).
When an entity is determining whether to assign deferred tax assets for NOL and credit carryforwards to a reporting unit, the entity should apply the criteria in ASC 350-20-35-39 through 35-40 (i.e., include the assets that will be employed in the operations of the reporting unit and that will be considered in determining the reporting unit’s fair value). These deferred tax assets could be used by the reporting unit and should be assigned to a reporting unit if they were included in determining the fair value of the reporting unit. For example, if the reporting unit is a separate legal entity and the assumption used in determining the fair value of the reporting unit was that it would be sold in a nontaxable transaction where the carryforwards would transfer to the buyer, then the deferred tax assets from the carryforwards generated by that entity should be assigned to the reporting unit in determining the reporting unit’s carrying value. Consider the following two scenarios.
Example 10-16: Allocation of NOL-Generated Deferred Tax Assets and Tax Credit Carryforwards to Reporting Unit
One of Entity A’s reporting units is represented by a separate legal entity, Sub X. Sub X has generated NOL and credit carryforwards for which Entity A has recognized deferred tax assets. Entity A believes that it would be feasible to sell the stock of Sub X in a nontaxable transaction, which would allow the transfer of Sub X’s NOL and credit carryforwards. Entity A also believes that marketplace participants would base their estimates of Sub X’s fair value on a nontaxable transaction. Entity A has determined that it would receive the highest economic value if it were to sell Sub X in a nontaxable transaction.
We believe that the DTAs related to Sub X’s NOL and credit carryforwards would meet the criteria in ASC 350-20-35-39 through 35-40. Therefore, these DTAs should be included in the carrying amount of the reporting unit.
Example 10-17: No Allocation of NOL-Generated Deferred Tax Assets and Tax Credit Carryforwards to Reporting Unit
Entity B has NOL and credit carryforwards for which it has recognized DTAs. Entity B’s NOL and credit carryforwards are usable only at the consolidated level, since Entity B’s reporting units are not separate legal entities, and not expected to be sold in a nontaxable transaction. Therefore, in determining the fair value of its reporting units, Entity B assumes that its reporting units would be sold in taxable transactions, which do not provide for the transfer of tax attributes (such as NOLs or the tax basis) to the buyer.
We believe that Entity B would not assign the DTAs for the NOL and credit carryforwards to its reporting units, because those DTAs do not meet the criteria in ASC 350-20-35-39 through 35-40.
If a company files a consolidated tax return and has established a valuation allowance against its deferred tax assets at the consolidated level, it should allocate the valuation allowance to each reporting unit based on the deferred tax assets and liabilities assigned to each reporting unit. It would not be appropriate for the company to evaluate each reporting unit on a “separate” return basis and thereby assess the need for a valuation allowance for each individual reporting unit. Unlike situations where separate financial statements of a consolidated entity are being prepared, the purpose of allocating a valuation allowance to reporting units is to determine the existing carrying value of the reporting unit. Therefore, it is appropriate to allocate the existing valuation allowance of the consolidated entity, rather than do an analysis “as if” the entity had filed a separate income tax return.
In step one of the goodwill impairment test, the fair value of a reporting unit should be based on an assumption regarding the structure of the disposal transaction and is a matter of judgment that depends on the relevant facts and circumstances (ASC 350-20-35-25). The assumed structure of the disposal transaction can affect the price a buyer is willing to pay for the reporting unit and the seller’s tax cost on the transaction. For example, in a taxable transaction, the net assets of the entity are considered sold and the buyer records a fair value tax basis in the net assets.
The buyer may be willing to pay more to acquire a reporting unit in a taxable transaction if the transaction provides a step-up in the tax basis of the acquired net assets. In a nontaxable transaction, the stock of the company is sold and the buyer records a fair value tax basis in the acquired stock, but carryover (or predecessor) tax basis in the net assets. The buyer may be willing to pay more to acquire a reporting unit in a nontaxable transaction if the reporting unit has significant net operating loss or tax credit carryforwards that the buyer would be able to utilize.
The gross proceeds expected to be realized from the disposal must be reduced by the seller’s tax cost. The seller’s tax cost should reflect, and can vary with, the structure of the disposal. For example, in a nontaxable sale, the seller’s gain (or loss), and thus the seller’s tax cost, is measured by reference to its tax basis in the stock of the reporting unit; in a taxable sale, the seller’s taxable gain (or loss) is measured by reference to the tax basis in the net assets of the reporting unit. The effect of existing tax attributes of the seller would be considered in measuring the seller’s tax cost.
In step two of the goodwill impairment test, the implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination (ASC 350-20-35-14). The determination of deferred income taxes included in the step two analysis should be calculated using the same assumption (i.e., taxable or nontaxable) that was used in determining the fair value of the reporting unit in step one (ASC 350-20-35-20).
In a nontaxable transaction, the historical tax bases of assets and liabilities, net operating losses, and other tax attributes of the target usually carry over to the buyer. Since identifiable net assets will be reflected at fair value for book purposes, the amount of deferred income taxes used in the analysis should reflect the difference in the fair value book bases and the carryover tax bases. A deferred tax asset is included in the step two analysis if there is carryover tax basis in deductible goodwill and it exceeds the implied fair value of book goodwill. Determining the amount of a deferred tax asset on goodwill requires an iterative calculation (see Section TX 10.7.2).
Generally, in a taxable transaction, the acquirer does not carry over the existing tax bases of the assets and liabilities within the target, nor does it carry over net operating losses and other tax attributes. Instead, the acquirer records on its tax-basis balance sheet the acquired assets and the assumed liabilities at their respective fair values for tax reporting purposes (pursuant to applicable tax law). In this case, since the tax basis in the acquired assets and assumed liabilities would generally equal the book basis, there would be no deferred taxes in the step two goodwill analysis.
Refer to Section BCG 11.5.2.5 of PwC’s A Global Guide to Accounting for Business Combinations and Noncontrolling Interests for a further discussion.
10.7.7.1 Deferred Tax Accounting for a Goodwill Impairment
When goodwill is impaired for financial reporting purposes, there may be a deferred tax impact. As discussed in Section TX 10.7, goodwill is separated into two components at the acquisition date, and as discussed in Section TX 10.7.5, no deferred tax is provided for changes in component-2 book goodwill. In situations where goodwill is not deductible for tax purposes, a goodwill impairment would have no corresponding tax effect. However, if goodwill is tax deductible, then the goodwill impairment must be allocated to the components.
We believe a reasonable methodology to allocate a goodwill impairment loss between the components would include the allocation of the loss proportionally to the book carrying amount of component-1 and component-2 goodwill. The amount allocated to component-1 book goodwill will either decrease a previously created deferred tax liability or create/increase a deferred tax asset. The amount allocated to component-2 book goodwill will have no deferred tax effect.
Example 10-18 illustrates the tax effect of a goodwill impairment loss when there is excess book-over-tax goodwill.
Example 10-18: Deferred Tax Effect of a Goodwill Impairment Loss: Excess Book-Over-Tax-Goodwill at Acquisition
Background/Facts:
Company A performs its annual goodwill impairment test and concludes that the goodwill for reporting unit X suffered an impairment loss of $400 million. The assets and liabilities in the reporting unit had been acquired four years ago in an asset acquisition accounted for as a business combination (i.e., a taxable transaction) and the related tax goodwill is deductible over 15 years. Assume an applicable tax rate of 40 percent:
Analysis/Conclusion:
The goodwill impairment loss of $400 million is allocated proportionately to component-1 and component-2 book goodwill based on their relative carrying amounts. Deferred taxes represent the temporary difference between component-1 goodwill and its tax basis multiplied by the applicable tax rate. The deferred tax asset of $24 million (($600 – $660) x 40%) would be subject to a valuation allowance if its recovery is not more-likely-than-not. No tax benefit is recorded for the component-2 goodwill impairment, because there is no current or future tax benefit associated with the component-2 book goodwill. In connection with recording the goodwill impairment loss of $400 million, Company A would record a tax benefit of $120 million.
If a deferred tax asset was recorded on the acquisition date for excess of tax-deductible goodwill over the amount of goodwill for financial reporting purposes (i.e., component-2 goodwill), subsequent impairment charges may (i) increase an existing or create a new deferred tax asset, or (ii) decrease or eliminate a deferred tax liability that was created subsequent to the acquisition through the amortization of tax-deductible goodwill.
Example 10-19 illustrates the tax effect of a goodwill impairment loss when there is excess of tax-deductible goodwill over the amount of goodwill for financial reporting purposes at acquisition.
Example 10-19: Deferred Tax Effect of a Goodwill Impairment Loss: Excess
of Tax-Deductible Goodwill Over the Amount of Goodwill for Financial Reporting Purposes at Acquisition
Background/Facts:
Company A acquired a business in a nontaxable transaction and accounted for the acquisition under ASC 805. At the acquisition date, Company A has goodwill for financial reporting purposes of $400 and tax-deductible goodwill of $900 (carried over from a prior acquisition). A deferred tax asset (DTA) for the excess tax-deductible goodwill of $200 is recorded at the acquisition date. The DTA (using a 40 percent tax rate) and resulting financial reporting goodwill were computed by applying the iterative calculation described in Section TX 10.7.2. The tax goodwill is deductible ratably over 10 years. In year 4, Company A performs its annual goodwill impairment tests and concludes that the goodwill for reporting unit X suffered an impairment loss of $200.
Analysis/Conclusion:
When a DTA is recorded on the acquisition date for excess tax-deductible goodwill, subsequent impairment charges will cause a remeasurement of deferred taxes.
In this example, activity for years 1–4 is presented below (in millions):
In general, when tax-deductible goodwill exceeds goodwill for financial reporting purposes, the decrease in tax basis from tax amortization first reduces the DTA recorded on the acquisition date before creating a DTL. The goodwill impairment loss reduces the carrying amount of book goodwill. There is no component-2 book goodwill, so there is no need to allocate the impairment between components. In this example, the book basis impairment loss reduces the carrying amount of goodwill for financial reporting purposes and results in an increase in the existing DTA. The resulting post-impairment DTA of $136 (($200 – $540) x 40%) would require a valuation allowance if its realization is not more-likely-than-not.
In contrast, an impairment loss in later years may reduce an existing DTL. For example, assume reporting unit X suffered a $200 impairment loss in year 8.
In this case, the $200 million book basis impairment loss reduces the carrying amount of goodwill for financial reporting purposes, and reduces the existing DTL from $88 to $8.
10.7.8 Disposal of Goodwill
In many jurisdictions goodwill is associated with the stock of a specific legal entity, whereas for book purposes goodwill is associated with a reporting unit. The reporting unit may include several legal entities or be limited to a portion of a legal entity. This can result in differences between the book and tax accounting for goodwill upon the disposal of a business. If the disposed business is a legal entity, any tax-deductible goodwill associated with that entity would be included in the determination of the taxable gain or loss. If the disposed operations are a business, ASC 350-20-35-52 requires the allocation of a reporting unit’s goodwill to (1) the business that was disposed of and (2) the remaining parts of the reporting unit, based on their relative fair values on the date of disposal. Once goodwill is characterized as component-1 or component-2, it retains this characterization as long as a reporting entity retains that goodwill. Therefore, upon disposal of a business that includes some or all of a reporting entity’s goodwill, a deferred tax adjustment would generally be required for disposal of component-1 but not for disposal of component-2 goodwill. Examples 10-20 and 10-21 illustrate the disposal of a business, including a portion of component-1 goodwill, resulting in a deferred tax adjustment to the reporting entity. Example 10-22 illustrates the disposal of a business, including a portion of component-2 goodwill, resulting in no deferred tax adjustment to the reporting entity.
Example 10-20: Disposal of Tax-Deductible Goodwill with Retention of Book Goodwill
Background/Facts:
Entity A acquired Entity B in a taxable business combination (i.e., Entity A treated the purchase as an asset acquisition for tax purposes), which gave rise to book and tax-deductible goodwill in equal amounts of $100. The business of Entity B and the associated goodwill are fully integrated into one of Entity A’s reporting units. In a later period, Entity A decides to dispose of the shares of Entity B, including Entity B’s operations. For tax purposes, the entire remaining tax-deductible goodwill of $70 ($100 initial basis less assumed tax amortization of $30) is included in the disposal. For book purposes, goodwill of $20 is allocated on a relative fair value basis to the disposed operation. As a result, $80 of the book goodwill is retained by the surviving reporting unit within Entity A ($100 initial value less $20 included in the disposed operation).
Analysis/Conclusion:
The disposal will result in a basis difference in the goodwill retained by Entity A, with book goodwill exceeding tax-deductible goodwill by $80. This gives rise to a deferred tax liability for the entire $80 taxable basis difference (i.e., Entity A compares nil tax-deductible goodwill to book goodwill of $80).
Example 10-21: Disposal of Book Goodwill with Retention of Tax-Deductible Goodwill
Background/Facts:
Entity A from the above example instead disposes of a significant portion of its operations but not its shares in Entity B. For tax purposes, the goodwill associated with the shares of Entity B would remain with Entity A. For book purposes, $80 of goodwill is allocated to the disposed operations on a relative fair value basis and included in the determination of the disposal gain or loss. Book goodwill of $20 remains in the reporting unit.
Analysis/Conclusion:
The disposal of component-1 goodwill will result in a basis difference in goodwill retained by Entity A, consisting of the remaining tax goodwill ($70) exceeding book goodwill ($20) by $50, which will give rise to a deferred tax asset (subject to the measurement criteria of ASC 740).
Example 10-22: Evaluating Deferred Tax Assets for Temporary Differences on Component-2 Goodwill after Disposition of the Entity That Generated the Goodwill
Background/Facts:
Entity A acquired Entity B in a nontaxable business combination. For tax purposes, the transaction resulted in a carryover basis in Entity B’s assets and liabilities. Because the tax basis carried over, and Entity B’s assets for tax purposes did not contain any tax-deductible goodwill, all of the goodwill recorded in purchase accounting was component-2 book goodwill (as defined in ASC 805-740-25-9). Entity B was subsequently integrated into Reporting Unit 2, and, as a result, Entity B’s goodwill was combined with the rest of Reporting Unit 2’s goodwill. Entity A’s structure is as follows:
In the current year, Entity A sold Business 3, which includes Entity B. The goodwill in Reporting Unit 2 was allocated to Business 3, based on the relative fair value of Business 3 and the retained operations of Reporting Unit 2, pursuant to ASC 350-20-35-53. This resulted in only a small amount of book goodwill being allocated to Business 3. Entity A had a significantly larger tax basis in Business 3, in large part due to Entity A’s acquisition cost for Entity B’s shares. The difference between the book and tax goodwill included in the measurement of the book and tax gain or loss produces a small gain for book purposes and a significant loss for tax purposes. The current tax benefit from the transaction has a disproportionate impact on the current-year effective tax rate.
Question:
Should Entity A record a deferred tax liability for the excess of book over tax goodwill remaining in Reporting Unit 2?
Analysis/Conclusion:
No deferred tax liability should be recognized in this instance. If for book purposes there is goodwill, with no tax basis, a deferred tax liability would not be recorded, pursuant to ASC 740-10-25-3(d). On the date Entity A acquired Entity B, the entire amount of book goodwill was classified as component-2 goodwill, because there was no tax goodwill in the transaction, and no deferred tax liability was recorded. The fact that only a portion of that goodwill was subsequently attributed to Entity B when it was disposed of does not change that characterization. Thus, the goodwill remaining in Reporting Unit 2 after the sale of Entity B continues to be component-2 goodwill for which no deferred tax liability would be recorded.
10.7.9 Bargain Purchase
Bargain purchase refers to a situation where the fair value of the net assets acquired exceeds the fair value of consideration transferred. Such excess is sometimes referred to as “negative goodwill.” In these situations the acquirer must reassess whether it has correctly identified all of the assets acquired and liabilities assumed and review the procedures used to measure the components of the acquisition to ensure all available evidence as of the acquisition date has been considered. The aggregate amount of fair value assigned to the acquired net assets may, after this review, still exceed the acquisition consideration and result in a bargain purchase gain (ASC 805-30-25-2).
The tax rules for each separate jurisdiction may require a different treatment for bargain purchases than that required under ASC 805. Tax rules often require the allocation of negative goodwill to certain assets through the use of the residual method, resulting in decreased tax bases. In the United States, for example, for tax purposes, the acquisition price is assigned to assets categorized in seven distinct asset classes, first to the assets in Class I and then successively through to Class VII. The consideration transferred is not allocated to a successive class until it has been allocated to the assets in the previous class based on their full fair values. This methodology can result in several classes of assets without tax bases and in temporary differences for a significant portion of all assets. The allocation of negative goodwill to reduce the tax bases of acquired net assets causes the book bases to exceed their respective tax bases, resulting in the recognition of deferred tax liabilities. The recognition of deferred tax liabilities then results in a reduction in the bargain purchase gain for financial reporting, and may result in the recognition of goodwill. Example 10-23 illustrates the recording of deferred tax balances in a bargain purchase situation.
Example 10-23: Recording Deferred Tax Balances in a Bargain Purchase
(U.S. Tax Jurisdiction)
Background/Facts:
Company A acquires Company B in a taxable acquisition. Total acquisition consideration amounted to $230 million, and the acquired fair value of the net assets equal $290 million, which results in the following allocation (in millions). Assume an applicable tax rate of 40 percent.
Analysis/Conclusion:
Further, assuming tangible property consists of three pieces of equipment, their new tax bases would be determined as follows (in millions):
For financial statement purposes, this transaction is a bargain purchase. Therefore, the assets are recorded at their fair value determined under ASC 805, and the bargain element of the transaction is recorded in earnings (ASC 805-30-25-2). The differences between the book and tax bases of the net assets acquired result in the recognition of deferred tax liabilities of $24 million (($290 – $230) x 40% tax rate). Therefore, the total amount of net assets recorded in acquisition accounting is $266 million ($290 – $24). The bargain purchase gain would be calculated as follows (in millions):
1 The bargain purchase gain is reflected in earnings.
10.8 Recording the Tax Effects of Transactions with Noncontrolling Shareholders
Once a parent controls a subsidiary, changes can occur in the ownership interests in that subsidiary that do not result in a loss of control by the parent. If changes occurring in a parent’s ownership interest after control is obtained do not result in a change in control of the subsidiary, those changes should be accounted for as equity transactions (ASC 810-10-45-23).
A noncontrolling interest (NCI) is the portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to the parent. In a transaction that results in a change in the parent’s ownership interest while the parent retains its controlling financial interest, the carrying amount of the NCI is adjusted to reflect the change in its ownership interest in the subsidiary’s net assets. Any difference between the fair value of the consideration received or paid and the amount by which the NCI is adjusted, is recognized in equity attributable to the parent (ASC 810-10-45-23).
The parent’s ownership interest in a subsidiary may change as a result of a variety of transactions while the parent retains its controlling financial interest. For example, a parent may purchase some of the subsidiary’s shares or sell some of the shares that it holds, a subsidiary may reacquire some of its own shares, or a subsidiary may issue additional shares. See Chapter BCG 6 of the PwC publication A Global Guide to Accounting for Business Combinations and Noncontrolling Interests for further discussion of the accounting for transactions with noncontrolling shareholders.
The direct tax effect of a transaction with noncontrolling shareholders that does not cause a change in control is generally recorded in equity (ASC 740-20-45-11(c)). However, care should be taken to distinguish between direct and indirect tax effects, because the treatment in the financial statements may differ for each, and sometimes the tax effect of a transaction comprises both direct and indirect components. For purposes of this section of the Guide, direct effects are those resulting from application of the relevant tax law to the transaction. Direct effects do not include those resulting from a change in an accounting assertion, election or assessment even though such a change may have been undertaken by the reporting entity in contemplation of the transaction. The remainder of this section discusses the accounting for direct and indirect tax effects of transactions with noncontrolling shareholders.
10.8.1 Direct Tax Impact of a Transaction with Noncontrolling Shareholders
The direct tax effect, net of any related valuation allowance, of a transaction with noncontrolling shareholders that does not cause a change in control is generally recorded in equity (ASC 740-20-45-11(c)). Subsequent release of the related valuation allowance would also be recorded in equity. Example 10-24 illustrates the recording of a direct tax effect of a transaction with noncontrolling shareholders.
Example 10-24: Recording the Direct Tax Effect of a Transaction with Noncontrolling Shareholders
Background/Facts:
Parent owns 100 percent of Company B, which has net assets of $200 million. Parent’s tax basis in its investment in Company B is $200 million (equal to the book basis). Company B issues additional shares to Company C, an unaffiliated third party, for cash of $80 million. The issuance of the additional shares dilutes Parent’s interest to 80 percent. After issuance of the additional shares, the ownership interests in the net assets of Company B are as follows (in millions). Assume an applicable tax rate of 40 percent.
Analysis/Conclusion:
1 $200 + $80 proceeds = $280.
The transaction would result in the following impact in the consolidated financial statements, before consideration of income taxes (in millions):
Assume the transaction is not a current taxable event to Parent. The transaction caused a $24 million increase in the book basis of Parent’s investment in Company B, but no change in the tax basis, thus creating a taxable temporary difference.
Unless Parent can establish its intent and ability to indefinitely delay reversal of the difference, Parent would record a DTL for the taxable temporary difference. Since the transaction is recorded directly in equity, the tax effect of the transaction, assuming a 40 percent tax rate, is also recorded directly in equity, as follows (in millions):
2 $224 book basis – $200 tax basis x 40% = $9.6.
10.8.2 Indirect Tax Impacts of a Transaction with Noncontrolling Shareholders
It is important to distinguish between direct and indirect tax effects, because the treatment in the financial statements may differ for each. For example, the purchase by a parent company of an additional interest in a controlled subsidiary may allow the parent for the first time to file a consolidated tax return. The ability to file a consolidated tax return may allow the company to change its assessment regarding its ability to realize existing deferred tax assets, causing the company to release all or a portion of its valuation allowance. Even though a transaction with noncontrolling shareholders may have caused the change in circumstances that allows the parent to realize (or conclude it may not realize) its deferred tax assets in the future, the change in valuation allowance results from a change in management’s assessment regarding the realization of deferred tax assets and is, therefore, an indirect effect of the transaction. The tax effect of a change in judgment about the realisation of deferred tax assets in future years is generally reflected in earnings, but is subject to the intraperiod allocation requirements (ASC 740-20-45-8(a)).
Some transactions may cause a direct and an indirect tax effect. Example 10-25 illustrates the recording of the direct and indirect tax effects of a transaction with noncontrolling shareholders.
Example 10-25: Recording the Tax Effects of a Transaction with Noncontrolling Shareholders
Background/Facts:
Parent owns and controls 100 percent of Company B, which is domiciled in a foreign jurisdiction. Parent’s book basis and tax basis in its investment in Company B is $300 million and $200 million, respectively. The difference between the book basis and tax basis is attributable to undistributed earnings of Company B. Parent has not historically recorded a deferred tax liability on the taxable temporary difference because of its intent and ability to indefinitely delay reversal of the difference. Parent sells 20 percent of Company B for $250 million. The sale of Parent’s investment is taxable at a rate of 40 percent.
Analysis/Conclusion:
The transaction would result in the following impact in the consolidated financial statements, before consideration of income taxes (in millions):
1 Book basis of $300 x 20% = $60.
Parent’s current tax consequence from the tax gain on sale of its investment in Company B is $84 million (($250 selling price – ($200 tax basis x 20% portion sold)) x 40% tax rate). The total tax consequence of $84 million comprises two components:
1. $8 million, which is the difference between the book basis and the tax basis (i.e., undistributed earnings of Company B) of the portion sold (($300 book basis – $200 tax basis) x 20% portion sold x 40% tax rate). This component is an indirect tax effect of the transaction. The tax consequence results from a change in assertion regarding the indefinite delay of the reversal of the outside basis difference, which is triggered by the decision to sell a portion of the investment in Company B. The outside basis difference is attributable to undistributed earnings of Company B and the tax effect of the change in assertion related to the outside basis difference is recorded in earnings (ASC 740-30-25-19).
2. $76 million, which is the difference between the selling price and the book basis for the portion sold (($250 selling price – ($300 book basis x 20% portion sold)) x 40% tax rate). This second component represents the economic gain on the sale and is a direct tax effect of the transaction. Because the difference between fair value and carrying amount of NCI is recorded in equity, the direct tax effect should also be recorded in equity.
The tax consequences are recorded as follows (in millions):
1 ($300 book basis – $200 tax basis) x 20% x 40% = $8.
2 ($250 selling price – $60 book basis) x 40% = $76.
3 ($250 selling price – $40 tax basis) x 40% = $84.
The change in assertion related to the indefinite delay of the reversal of the outside basis difference will impact the effective tax rate in the period in which the change occurs.
Recording a tax related to unremitted earnings of the foreign subsidiary is a change in assertion regarding indefinite reinvestment and is generally recorded in continuing operations. In fact, the tax liability related to the unremitted earnings of the subsidiary may be required to be recorded in a period preceding the actual sale transaction, because the liability should be recorded when the company’s assertion regarding indefinite reinvestment changes.
In light of the disposal of a portion of the Parent’s investment in Company B, Parent should also reassess its intent and ability to indefinitely delay reversal of the remaining outside basis difference in the portion retained and assess whether a DTL should be recorded on such difference.
10.9 Transactions under Common Control
Common control transactions occur frequently, particularly in the context of group reorganizations, spin-offs, and initial public offerings. Combinations between entities that are under common control are excluded from the scope of business combinations. However, the guidance on accounting for common control transactions did not change and is carried forward in ASC 805-50.
Common control transactions are generally accounted for based on the nature of the transaction. For example, transactions involving the transfer of an asset (such as a building) are accounted for at historical carrying values. Transactions involving the transfer of a business will result in a change in reporting entity for the entity receiving the assets and require the application of the procedural guidance in ASC 805-50. Transfers of net assets, depending upon whether its nature is considered to be similar to assets or a business, will be accounted for either at historical carrying values or based on the procedural guidance. Companies will need to use judgment to determine the nature of the transaction. The accounting for common control transactions are discussed more fully in BCG Appendix A of PwC’s publication A Global Guide to Accounting for Business Combinations and Noncontrolling Interests.
10.9.1 Accounting and Reporting by the Receiving Entity
10.9.1.1 Basis of Transfer
When accounting for a transfer of assets or exchange of shares between entities under common control, the entity that receives the net assets or the equity interests should initially recognize the assets and liabilities transferred at their carrying amounts in the accounts of the transferring entity at the date of the transfer. If the carrying amounts of the assets and liabilities transferred differ from the historical cost of the parent of the entities under common control, for example, because push-down accounting had not been applied, then the financial statements of the receiving entity should reflect the transferred assets and liabilities at the historical cost of the parent of the entities under common control (ASC 805-50-30-5).
10.9.1.2 Procedural Guidance for Presenting a Change in Reporting Entity
If a transaction combines two or more commonly controlled entities that historically have not been presented together, the resulting financial statements are, in effect, considered those of a different reporting entity. This results in a change in reporting entity, which requires retrospectively combining the entities for all periods presented as if the combination had been in effect since inception of common control (ASC 250-10-45-21). Certain adjustments to the financial statements of the new reporting entity may be required. The types of adjustments that may be necessary are discussed in the procedural guidance of (ASC 805-50).
The procedural guidance, does not specifically address the accounting for the deferred tax consequences that may result from a transfer of net assets or the exchange of equity interests between entities under common control. Although such a transaction is not a pooling of interests, we believe that the historical guidance related to recording the tax effects of pooling of interests transactions should be applied by analogy.2 In the periods prior to the combination date, a combining entity’s deferred tax assets (e.g., operating loss carryforward) cannot offset the other entity’s taxable income unless allowed under the tax law. However, future taxable income of the combined operations subsequent to the combination date should be considered in assessing the need for a valuation allowance in the restated periods prior to the combination date. Similarly, any tax law limitations on the use of combined attributes subsequent to the transfer or exchange date should also be considered. Accordingly, in restating periods prior to the transfer or exchange, a valuation allowance against deferred tax assets that is necessary for the combined entity may be more or less than the sum of the valuation allowance in the entities’ separate financial statements before the transfer or exchange. If the transfer or exchange causes any change in the combined entities’ valuation allowance, the reduction or increase should be recognized as part of the adjustment to restate the entities’ prior-period financial statements on a combined basis.
2 FAS 109, par. 270–271.
For purposes of restating periods prior to the transfer or exchange, hindsight is required to take into account (i) that the transfer or exchange has occurred and (ii) the amount of any resulting tax law limitations on the use of carry-over tax benefits after the transfer or exchange. However, hindsight is precluded for purposes of assessing pre-transfer or exchange estimates of future taxable income. In other words, any reduction in the valuation allowance for either entity’s deferred tax assets would be reflected in the years that the deductible differences or carryforwards arose, provided that one of the following conditions exists:
Estimates that would have been made at the time of future combined taxable income (i.e., after the transfer or exchange, other than reversing differences and carryforwards of the other entity) would have been sufficient for realization of the deferred tax assets.
The other entity’s taxable differences existing at that time will generate sufficient future post-transfer or exchange taxable income to ensure realization of the deferred tax assets.
A valid tax-planning strategy ensures realization of the deferred tax assets.
If none of these conditions were met in the year that the deductible differences and carryforwards arose, the reduction in the valuation allowance will be reflected in the first subsequent year in which one or more of these conditions are met.
In addition to adjustments that may be required to restate prior periods discussed above, in a taxable transfer or exchange new tax bases of assets and liabilities may be established. Because a new basis is not established for book purposes, taxable temporary differences may be reduced or eliminated, and deductible temporary differences may be increased or created. As of the transfer or exchange date, the tax effects attributable to any change in tax basis (net of valuation allowance, if necessary) should be charged or credited to contributed capital. If a valuation allowance is provided against the deferred tax assets at the combination date, any subsequent release of the valuation allowance should be reported as a reduction of income tax expense and reflected in continuing operations, unless the release is based on income recognized during the same year and classified in a category other than continuing operations, consistent with the guidance at Section TX 12.2.2.2.3.
Example 10-26: Assessing Valuation Allowances for a Transfer of Entities Under Common Control
Background/Facts:
Entity X controls both Entity Y and Entity Z. Entity Y acquires Entity Z in a nontaxable acquisition in March 2005 (fiscal year-end for each entity is December 31). The acquisition is accounted for in Entity Y’s financial statements in a manner similar to how the entity would have accounted for a pooling of interests. Entity Y’s prior-period financial statements will be restated retroactively for the effects of the “acquisition” (i.e., transfer of entities under common control).
Historically, Entity Y has been a profitable entity. Entity Z has not had a history of profitability, and before the acquisition it had a full valuation allowance for its DTAs. Following the acquisition/combination, Entity Y will file a consolidated tax return, one that includes the results of Entity Z.
Question:
In Entity Y’s restatement of its prior-period financial statements to include Entity Z, how should the need for a valuation allowance relative to Entity Y and Entity Z’s DTAs be assessed?
Analysis/Conclusion:
The DTAs should be evaluated for realizability in accordance with ASC 740 at the time of the combination and for prior periods. The fact that the companies will file a consolidated tax return for periods after the legal combination in March 2005 should be taken into consideration. By analogy to the historical guidance on recording the tax effects of pooling-of-interest transactions, in determining the need for a valuation allowance for prior periods, the estimated combined future taxable income of Entity Y and Entity Z after their legal combination in March 2005 should be considered. If the valuation allowance is reduced as a result of the common control transaction, the reduction should be recorded as a decrease in income tax expense in the period that it became apparent that future taxable income could be a source of recovery (i.e., potentially a period prior to the period of the actual legal combination/transfer). In determining the appropriate period for reversal, hindsight is precluded for purposes of assessing estimates of future taxable income.
10.10 Other Considerations
10.10.1 Asset Acquisitions and Nonmonetary Exchanges
The acquisition of an asset or group of assets that does not meet the definition of a business is accounted for as an asset acquisition. Such assets may be acquired through a monetary or nonmonetary exchange transaction. Typically in a monetary exchange, the book and tax basis of the asset acquired are equal at the transaction date. Therefore, there is no deferred tax to record. Even if there is an acquired temporary difference (i.e., the book and tax basis differ at the transaction date) there would generally be no immediate income tax expense (ASC 740-10-25-51). For example, consider an asset acquired by purchasing the shares of an entity (not a business) in which the tax basis of the asset is lower than the price paid to acquire the shares and carries over to the acquirer. The resulting deferred tax liability is recognized by increasing the recorded amount of the asset. This accounting increases the deferred tax liability, which further increases the asset. To address the iterative effect, the deferred tax liability can be determined by using a “simultaneous equations method.”
Assets acquired through a nonmonetary exchange may result in a temporary difference, generally giving rise to a deferred tax liability due to differences in book and tax basis. For example, consider a transaction whereby the tax law provides for the acquirer’s tax on the exchange transaction to be deferred and the acquirer’s tax basis in the asset disposed carries over to be the tax basis in the asset received (e.g., a like-kind exchange). A deferred tax liability should be recorded because the basis difference does not arise from the acquired asset’s initial recognition, but instead arises because of the deferral of the tax on the asset disposed. As a result, the tax effect flows through the income statement in the same period as the accounting gain.
Example 10-27 illustrates the income tax accounting for a tax-free exchange of nonmonetary assets.
Example 10-27: Income Tax Accounting for a Tax-Free Exchange of Nonmonetary Assets
Background/Facts:
Entity X acquires Asset B in exchange for Asset R. The fair value of Asset B is $150. The carrying value of Asset R is $100 and the tax basis is $80, resulting in an existing deferred tax liability of $8 (assuming a 40 percent tax rate). For tax purposes, the transaction is structured such that Entity X can defer the taxable gain on the exchange. The tax basis in Asset R of $80 will become the tax basis in Asset B. Assume that the nonmonetary exchange has commercial substance, and is not an exchange transaction to facilitate sales to customers. Therefore, the exchange is measured at fair value.
Analysis/Conclusion:
Entity X records a gain of $50 on disposal of Asset R (based on the difference in the fair values of Asset B and Asset R) and a corresponding DTL of $20 on the gain.
Entity X records the following entries on the transaction date:
1 Gain on sale of $50 x 40% = $20.
The total DTL related to Asset B is $28 (($150 book basis – $80 tax basis) x 40% = $28). The above entry increases the DTL from $8 to $28.
The accounting for asset acquisitions that are not business combinations is discussed in BCG Appendix C of PwC’s publication A Global Guide to Accounting for Business Combinations and Noncontrolling Interests.
10.10.2 Fresh Start Accounting
A company emerging from bankruptcy that prepares financial statements in accordance with ASC 852 Reorganizations (ASC 852) (i.e., “fresh-start” accounting), might have recorded a valuation allowance against its deferred tax assets at the plan confirmation date. Under ASC 852-740-45-1, the benefit from releasing a valuation allowance related to preconfirmation deferred tax assets after the plan confirmation date is recorded as a reduction to income tax expense. Similarly, adjustments to uncertain tax positions made after the confirmation date should generally be recorded in earnings (in income tax expense), consistent with the guidance for business combinations. PwC’s Guide to Accounting for Bankruptcies and Liquidations provides additional guidance on the topic.
10.10.3 LIFO Inventories Acquired in a Nontaxable Business Combination
Temporary differences that arise from last-in, first-out (LIFO) inventories are not an exception to the basic principles of ASC 740. However, accounting for deferred taxes on LIFO inventories may present some unique issues in the context of a business combination. Example 10-25 illustrates how LIFO inventories acquired in a nontaxable business combination would be reflected in the acquiring entity’s financial statements and U.S. federal income tax return when the separate LIFO pools of each entity are combined or combinable for tax purposes. Less complex and more common situations are cases in which the acquired entity is not liquidated into the acquiring entity, and cases in which the LIFO inventories consist of dissimilar products and thus are not combined.
Example 10-28: Inventories Acquired in a Nontaxable Business Combination
Entity P and Entity S use the LIFO-inventory cost method. Entity P acquires Entity S in 1996 in a nontaxable business combination. For federal income tax purposes, the historical LIFO cost basis of the inventory of Entity S survives the acquisition.
Entity S is immediately liquidated into Entity P, and its entire operations are combined with Entity P. The inventories of Entity P and Entity S are similar (both largely consist of Product A), and will be treated as a single pool.
Assume the following facts about Product A:
Entity S and Entity P have 10 units and 80 units, respectively, of Product A on hand on the acquisition date.
In acquisition accounting, one unit of Product A inventory was valued at $10.
The table below presents (1) “Product A inventory by LIFO layer” held by Entity P and Entity S before Entity S’s liquidation, and (2) the “combined Product A inventory by LIFO layer” held by Entity P after liquidating Entity S:
1 On the acquisition date, the LIFO inventories of Entity S are reflected in Entity P’s financial statements as one layer, at a fair value of $10 per unit.
2 For federal income tax purposes, the acquired LIFO inventories are carried over at the same LIFO basis and LIFO layers. Under ASC 740, a deferred tax liability would be recognized in acquisition accounting for the excess of book value for LIFO inventories over the tax basis.
On the acquisition date of a nontaxable business combination, the financial statement carrying value for acquired assets (e.g., property, plant and equipment) will generally exceed the carryover tax basis. This situation can create additional differences between book and tax. For example, a higher value for property, plant and equipment for book over tax will create higher depreciation costs for book over tax. If that depreciation is included in the cost of inventory, then the cost of inventory in periods subsequent to the acquisition will be higher for book than for tax.
10.11 Questions and Answers—Additional Implementation Guidance
Measuring Acquiree’s and Acquirer’s Deferred Taxes
10.11.1 Question 1: If an acquiree’s unborn foreign tax credits reduce the amount of the acquirer’s deferred tax liability on its outside basis differences, where are the effects recorded?
Answer: The tax effects of unborn foreign tax credits are recorded outside of acquisition accounting. An acquirer might have a deferred tax liability for an investment in a foreign subsidiary. In measuring such deferred tax liability, the acquirer considers the expected manner of recovery (e.g., dividends, liquidation). The tax rate used to measure the liability should reflect any applicable deductions, credits or withholding tax.
An acquirer may have “unborn” foreign tax credits (FTCs). That is, foreign taxes that have been paid or accrued by the foreign subsidiary but which are not yet eligible as a credit to the parent because the earnings remittance, or other tax triggering event, has not yet occurred. These unborn FTCs do not currently exist as a separate tax asset, but will be generated upon reversal of an outside basis difference (e.g., remittance of earnings). If the acquiree’s unborn FTCs change the measurement of the acquirer’s deferred tax liability on its outside basis differences, the reduction in the acquirer’s deferred tax liability is recorded outside of acquisition accounting.
The result is different if the FTCs have been generated and exist as a separate tax asset of the acquiree. For example, an acquiree may have a deferred tax asset for FTC carryforwards (i.e., for credits that have already been generated). The deferred tax asset is recorded in acquisition accounting. In this situation, even though the FTC carryforwards may reduce the amount of tax paid when the acquirer’s taxable temporary difference reverses, the FTC carryforward is a separate tax asset acquired in the business combination, and therefore, should be reflected in acquisition accounting. This is true even if the acquiree previously had a valuation allowance against the FTC carryforward deferred tax asset but the acquirer determines a valuation allowance is not required.
10.11.2 Question 2: If an acquirer’s unborn foreign tax credits reduce an acquiree’s outside basis difference, where are the effects recorded?
Answer: The tax effects of an acquirer’s unborn foreign tax credits are recorded in acquisition accounting. An acquirer may have “unborn” FTCs (See Section TX 10.11.1) that are used in measuring deferred taxes on outside basis differences. The impact of the unborn FTCs should be considered in measuring the acquiree’s deferred tax liability which is recorded in acquisition accounting.
The result is different if the FTCs have been generated and exist as a separate tax asset. For example, the benefit from releasing a valuation allowance against an acquirer’s deferred tax asset for FTC carryforwards (i.e., for credits that have already been generated) is recorded outside of acquisition accounting. The distinction is that FTC carryforwards are a separate tax return attribute for which a deferred tax asset is recorded, whereas an unborn FTC is not a separate tax asset and is only considered in measuring other deferred taxes (e.g., an acquiree’s outside basis difference).
10.11.3 Question 3: Are there circumstances when the effects of tax elections and post-acquisition transactions can be recognized as part of the acquired net assets recorded in acquisition accounting rather than recognized outside of acquisition accounting?
Answer: Business combinations often involve a considerable amount of business, legal and tax planning. Tax effects can arise from events ranging from tax-specific elections to more complex reorganizations and business integration actions. These events may alter income taxes expected to be incurred on recovery of acquired temporary differences. The question that often arises is whether to account for the tax effects of such events in acquisition accounting.
The fair value accounting guidance in the business combination standard is based upon market participant assumptions, under which the effects of buyer-specific decisions and transactions are generally excluded from acquisition accounting. However, the standard excludes income taxes from the fair value recognition and measurement accounting. In accounting for income taxes in acquisition accounting, the requirements in ASC 740 must be followed [ACS 805-20-25-16 through 25-17, ASC 805-740-25-2 and ACS 805-740-30-1].
ASC 740 provides the recognition and measurement framework for income taxes. There is, however, no direct guidance that addresses whether the tax effects of elections or post-acquisition transactions should be included in acquisition accounting and practice in this area is evolving. We believe a buyer’s expected manner of recovery should be considered in the recognition and measurement of deferred taxes relating to acquired temporary differences. This requires consideration of specific facts and circumstances, and the relevant tax laws, to determine whether the tax effects of a particular event should be recorded in acquisition accounting.
The decision might be straightforward when, for example, the seller and buyer agree to make a tax election to treat a share purchase as an asset purchase for tax purposes, thus providing a step-up in the inside tax bases of acquired assets. The buyer is thus able to acquire, through deal negotiation, assets with stepped-up tax bases and should account for the tax election effects in acquisition accounting. However, often the decision is not straightforward and, in those circumstances, consultation with the Accounting Services Group within PwC’s National Professional Services Group should be considered.
We believe the following factors should generally be considered:
Whether the election or transaction is available and contemplated as of the acquisition date, or within the measurement period though based on information and facts that existed at the acquisition date.
Whether the election or transaction is primarily within the acquirer’s control with no significant complexities or uncertainties as to whether the transaction will actually be completed.
Whether the acquirer is required to make a payment (separate from consideration exchanged for the business) or forgo tax attributes to obtain the tax benefits; in this regard, the mere realization, or settlement of an acquired deferred tax liability is not considered a separate payment.
Whether other significant costs will be incurred to implement the transaction.
For tax effects to be recorded in acquisition accounting, the election or transaction should be known or knowable and considered as of the acquisition date (even if the final decision to implement it occurs after the acquisition date). This might include, for example, transactions that the seller initiated or started prior to the acquisition which the buyer intends to complete. Actions that are based on information that was not known or knowable, or circumstances that did not exist as of the acquisition date are based upon new information and their effects should be accounted for outside of acquisition accounting. Acquisition accounting effects must also be primarily within the acquirer’s control. If implementation is contingent on obtaining third-party approval (including a tax ruling) or meeting legal or regulatory requirements, it generally is not primarily within the acquirer’s control. If a separate payment (or sacrifice of tax attributes) is required to obtain tax benefits the effects would generally be recorded outside of acquisition accounting. If significant costs other than payment to a taxing authority must be incurred to implement the transaction it may indicate that, consistent with the expensing of such costs, the tax effects should also be expensed.
It is also important to distinguish transactions that occur after the measurement period from those that are substantially completed within measurement period. The tax effects of the former would generally be recognized outside of acquisition accounting, while tax effects of the latter would be recognized in acquisition accounting assuming the guidelines set forth above were supportive.
In cases where a step-up in basis of tax-deductible goodwill is obtained through a transaction that occurs after the measurement period, a deferred tax asset is recorded if the new tax basis exceeds the book basis in the goodwill (ASC 740-10-25-54) (a deferred tax liability is not recorded if the book basis exceeds the new tax basis). We are aware of another acceptable view under which the newly arising tax goodwill is viewed as a separate unit of account and is not compared to the pre-existing book goodwill. Under that view, a deferred tax asset is recorded through the income tax provision for the full tax basis, subject to the deferral provisions related to intra-entity asset transfers (ASC 740-10-25-3(e)). The view applied for such a tax basis step-up in goodwill constitutes an accounting policy that should be followed consistently in similar circumstances.
Note that certain post-acquisition transactions might involve a transfer of intellectual property (IP) acquired in a nontaxable stock acquisition to an IP holding entity. These transactions might result in current tax based upon the IP’s fair market value on the transfer date or future tax based on future income derived from the IP. Sometimes the IP transfer value determined for tax purposes includes goodwill value and the question is whether it is appropriate to recognize a deferred tax liability in excess of the otherwise determined deferred tax liability on the acquired taxable temporary difference in the IP. We believe that recognition of an acquired deferred tax liability in excess of the underlying acquired taxable difference is prohibited under ASC 740 as it would be tantamount to recognition of a deferred tax liability on acquired non-deductible goodwill. The additional tax (over and above the acquired deferred tax liability) should be recognized through the income tax provision no sooner than the transfer period, subject to the tax recognition exception for intra-entity transfers of assets (ASC 740-10-25-3(e)).
For additional guidance related to the foregoing topics, refer to:
TX 2.3.4.1.3 for discussion of the accounting for intra-entity IP migration arrangements;
TX 8.6.3 for discussion of the accounting for a change in tax status as part of a business combination;
TX 10.4.2 for discussion of expected manner of recovery and implications on tax payable from the recovery of acquired assets;
TX 10.4.3 and Example 10-2 for discussion of the accounting for outside basis differences and indefinite reinvestment assertion; and
TX 10.11.2 for discussion of the accounting for acquirer’s unborn foreign tax credits and their effect on measurement of acquired deferred tax liabilities.
Examples 10-29 and 10-30 illustrate the above guidance on accounting for tax effects of certain post-acquisition elections and transactions. (Example 10-2 illustrates application of deferred tax recognition and measurement to an acquired outside basis difference when an acquirer implements an IRC Section 304 restructuring following a business combination).
Example 10-29: Accounting for Income Tax Effects of a Tax-Free Merger Occurring Within the Acquisition Accounting Measurement Period
Background/Facts:
Company X, a US multinational, has acquired, through a wholly-owned acquisition holding company in Brazil, the stock of Company Y, a foreign company domiciled in Brazil. The acquisition, accounted for under the business combination standard, is treated as a nontaxable acquisition in Brazil, and Company Y’s tax bases carry over to the holding company.
Pursuant to Brazilian tax law, affiliated entities located in Brazil can do a merger to combine legal entities and operations generally without incurring a tax cost. There are often business and tax motivations for such mergers, including streamlined operations, reduced administrative and legal costs, and a tax basis step-up in the acquired assets. These mergers can be executed anytime after an acquisition and, from a tax law perspective, are typically considered more-likely-than-not to be sustained, provided the entities have business substance. No formal approval or ruling from the taxing authority is required, and external approvals (e.g., obtaining certain business permits) generally are considered perfunctory.
During the initial due-diligence process, Company X explored the merits of a merger in Brazil but had not definitively concluded at the acquisition date whether to undertake the merger. Subsequently, Company X concludes that it will merge the Brazilian holding company into Company Y (i.e., downstream merger). The decision is based on further analysis of information and facts that existed at the acquisition date. The measurement period per ASC 805-10-25-14 is still open. The merger transaction results in a tax basis step-up in Company’s Y assets, including acquired tax-deductible goodwill.
Analysis/Conclusion:
Under this fact pattern, the anticipated deferred income tax benefit from a tax basis step-up should be incorporated into the recognition and measurement of acquired deferred taxes. This is because the merger transaction and its intended favorable tax consequences are available and considered by Company X as of the acquisition date. That is, the merger transaction and its expected tax effects are based on information and facts existing as of the acquisition date. It is also primarily within Company X’s control and ability as there is no substantive approval or review process. Additionally, Company X is not required to make a separate tax payment or incur significant costs separate from the consideration exchanged to acquire Company Y.
Example 10-30: Deferred Tax Accounting When a Planned Post-acquisition Restructuring Will Impact the Ability to Benefit from Acquired Net Operating Losses
Background/Facts:
Company X acquires in a nontaxable transaction 100 percent of the stock of Company Y. Company Y has state net operating loss carryforwards (NOLs) at the acquisition date in the single state in which it operates. The change in control of Company Y does not impact the utilization of the NOLs under state law. Company X has no presence in that state, which is a non-unitary separate filing state. There is sufficient evidence that the NOLs would be realized in the future based on the operations of Company Y in place as of the acquisition date; however, Company X has a definitive plan to move Company Y’s headquarters and operations to another state shortly after the acquisition. Because of this planned post-acquisition restructuring action, Company X does not expect the NOLs related to Company Y’s previous state of domicile to be realized.
Analysis/Conclusion:
In the fact pattern described above, we believe there are two alternative views:
View A—Record a DTA for the full amount of acquired state NOLs as part of acquisition accounting and record a valuation allowance and related deferred tax expense in continuing operations for the portion of the NOLs not expected to provide a future tax benefit (assuming the relocation occurs shortly after the acquisition). Under this view, the buyer is precluded from considering the effects of restructuring actions it expects to take after the acquisition by analogy to the guidance in ASC 805-20-25-2, which requires that restructuring costs the buyer expects but is not obligated to incur be recorded outside of acquisition accounting.
View B—Record a DTA and a valuation allowance for the portion of the NOLs not expected to provide a future tax benefit as part of acquisition accounting. Under this view, Company X’s expected manner of recovery should be considered in assessing recoverability of acquired DTAs. In that regard, all available evidence shall be considered, including planned actions that are primarily within Company X’s control and would affect its ability to realize a benefit from acquired state NOLs.
While both views above represent acceptable positions based on the facts presented, there may be situations where only one view would be supportable. For example, View A may be the only supportable answer if Company X did not have any intention of relocating Company Y at the acquisition date, but decided to do so as a result of having been subsequently offered significant government economic incentives.
In some circumstances, these two views may also be applicable in choosing the jurisdictional tax rate to be applied to acquired temporary differences when a post-acquisition relocation is anticipated. For example, if the acquirer plans to relocate an acquiree’s operation from State X to State Y, the view chosen would determine how to account for the effect of the difference in the states’ tax rates on acquired temporary differences.
In situations where either view is supportable, appropriate financial statement disclosures should be provided.
Deferred Taxes Related to Goodwill
10.11.4 Question 4: For purposes of determining whether to record a deferred tax asset for goodwill, how should book goodwill be compared to tax-deductible goodwill in a business combination involving multiple jurisdictions?
Answer: Tax-deductible goodwill in each jurisdiction will need to be compared to book goodwill allocated to each jurisdiction to determine the related temporary differences. ASC 740-10-30-5 requires that deferred taxes, including goodwill, be determined separately for each tax-paying component in each jurisdiction.
Example 10-31 illustrates this guidance.
Example 10-31: Comparison of Book Goodwill to Tax-Deductible Goodwill Involving Multiple Jurisdictions
Background/Facts:
Company A buys Subsidiary B in a nontaxable business combination. Subsidiary B has operations in the U.S. and Germany. As a result of the transaction, Company A recorded a total amount of $600 book goodwill. $500 of that total amount is associated with U.S. operations, while the remaining $100 is associated with German operations. Carryover tax-deductible goodwill acquired in the transaction totals $500; $200 of which is associated with legal entities in the U.S. and $300 of which is associated with legal entities in Germany.
Analysis/Conclusion:
The comparison of book to tax-deductible goodwill at a jurisdictional level yields the following results:
At the acquisition date, the acquirer would not record a DTL for goodwill associated with the U.S. jurisdiction because book goodwill exceeds the tax-deductible goodwill. However, for goodwill associated with the German jurisdiction, the acquirer would record a DTA in acquisition accounting because tax-deductible goodwill exceeds book goodwill.
Tax Indemnifications
10.11.5 Question 5: Where should adjustments to an indemnification asset for an income tax liability be recorded in the income statement?
Answer: Adjustments to the indemnification asset should be recorded in pretax income, not as a part of income tax expense. ASC 740 narrowly defines the term “income taxes” as domestic and foreign taxes based on income (ASC 740-10-20). Recoveries under an indemnification agreement do not appear to fit within the scope of this definition. Therefore, although dollar-for-dollar changes in the income tax liability and the related indemnification will offset on an after-tax basis, pretax income and income tax expense will move inversely as the amount of the income tax liability and related indemnification asset change.
Measurement Period Adjustments
10.11.6 Question 6: An acquirer might release all or a portion of its valuation allowance as a result of an acquisition. What is the appropriate accounting if a measurement period adjustment impacts that earlier valuation allowance release?
Answer: Measurement period adjustments to acquired assets and assumed liabilities are reflected retrospectively (i.e., as of the acquisition date) in the financial statements. In general, any changes to an acquiring company’s deferred tax assets that result directly from measurement period adjustments should also be retrospectively recorded. Example 10-32 illustrates this guidance.
Example 10-32: Measurement Period Adjustments Related to Deferred Taxes
Background/Facts:
Company A acquired Company B in a nontaxable business combination in the first quarter of 2010. One of Company B’s more significant assets was an office building that had no remaining tax basis. Company A recorded the office building at a provisional fair value of $1,000 and recorded a corresponding DTL of $400 (40 percent rate) at the acquisition date. Company A had pre-existing DTAs of $600, for which there was a full valuation allowance in prior periods. Solely as a result of the business combination and the existence of acquired DTLs, Company A released $400 of its valuation allowance and recognized the benefit in the income statement at the acquisition date.
In the second quarter of 2010, Company A completed its measurement of the acquisition-date fair value of the office building when it received a third-party appraisal report. The appraisal indicated that the fair value of the building at the acquisition date was $700, resulting in a DTL of $280 (and not the $400 previously recorded). Accordingly, the valuation allowance reversal in the first quarter was overstated by $120.
Analysis/Conclusion:
The accounts should be retrospectively adjusted to reflect the final valuation of the building, the resulting revised depreciation and the corresponding tax effects, including the adjustment of $120 to the valuation allowance.
10.11.7 Question 7: How should companies determine whether a change in an income tax uncertainty is a measurement period adjustment?
Answer: A change in an income tax uncertainty that is based upon facts and circumstances that existed as of the acquisition date is recorded as a measurement period adjustment (ASC 805-10-25-13 through 25-14). For example, during the initial due diligence, the acquirer may have identified uncertain tax positions of the acquiree and made a preliminary estimate of the amount, if any, of the related liability. That preliminary estimate is recorded in acquisition accounting. If during the measurement period, the acquirer performs a more detailed analysis of information that existed at the acquisition date and determines that an adjustment is necessary, the adjustment should be recorded retrospectively in acquisition accounting. Similarly, if during the measurement period the acquirer discovers an uncertain tax position that was not identified in its due diligence but which existed at the acquisition date, the accounting for that position should be recorded retrospectively in acquisition accounting.
ASC 740-10-25-14 provides that subsequent changes in judgment that lead to changes in an uncertain tax position should be recognized in the period in which the change in facts occurs. Changes in judgment about an uncertain tax position should result from new information and not from a new evaluation or new interpretation of information that was previously available. “New information” in this context represents a change in circumstances, and the resulting adjustment from the change in judgment would not be a measurement period adjustment.
If the adjustment arises from an identifiable post-acquisition event, then it should be recorded outside of acquisition accounting (even if still within the measurement period). On the other hand, if the adjustment results from the discovery of facts and circumstances that existed at the acquisition date, then it should be recorded as part of acquisition accounting.
Post Measurement Period Adjustments
10.11.8 Question 8: How should an adjustment be recorded when a company determines that the balances recorded in its acquisition accounting are incorrect subsequent to the completion of the measurement period?
Answer: The treatment of any resulting adjustment will depend on its nature:
1. Whether the information leading to the adjustment was readily available at the time of the acquisition and involved a clear misapplication of facts, or
2. Whether the adjustment is the result of events or additional information arising subsequent to the acquisition.
In other words, is the adjustment the result of an error in the application of the facts as they existed or is the adjustment the result of a change in estimate? If the former, the adjustment should be treated as an error and evaluated in the context of the initial acquisition accounting, after appropriate considerations of the materiality of the error on past periods. If the latter, the adjustment should be recorded through the income statement in the current period. See Section TX 17.1.1.4.8 for further discussion on discerning an error from a change in accounting estimate.
Interplay between Acquisition Accounting and the Exceptions to Deferred Tax Accounting for Intercompany Asset Transfers and Foreign Currency Differences
10.11.9 Question 9: What are the income tax accounting implications of acquiring an entity with pre-existing deferred charges resulting from intercompany transfers of assets?
Answer: The exception in ASC 740-10-25-3(e), which prohibits the recognition of the tax effects of intercompany transfers of assets, does not apply at the acquisition date. That is, a deferred tax liability (or asset) is recorded for the amount of the assigned value (resulting from the purchase price allocation) that exceeds (or is less than) the acquirer’s actual tax basis. After the acquisition date, any current and deferred taxes on any intercompany transfers of assets are subject to the exception in ASC 740-10-25-3(e), See Section TX 2.3.4 for further discussion on the tax effects of intercompany transactions.
10.11.10 Question 10: What are the income tax accounting implications of acquiring an entity where the acquiree’s functional currency is not the local currency?
Answer: If an entity functional currency differs from its local currency, certain of the entity’s assets and liabilities (e.g., nonmonetary assets) will be remeasured in future periods at “historical” currency rates. The historical rate for assets and liabilities acquired in a business combination is the rate at the date of the combination. The exception in ASC 740-10-25-3(f) that prohibits recognition of deferred taxes for differences that arise from changes in exchange rates or indexing for tax purposes on assets and liabilities that are remeasured at historical exchange rates does not apply at the acquisition date. Therefore the difference between the fair value of acquired assets and liabilities measured in the functional currency at the acquisition date and the tax basis is a temporary difference for which a deferred tax asset or liability is established on the acquisition date.
The exception in ASC 740-10-25-3(f) does apply to changes in the temporary difference post-acquisition (see Section TX 2.3.5).
Exchanges of Assets between Companies
10.11.11 Question 11: What are the income tax accounting implications of a business combination where the consideration transferred includes an equity investment (e.g., an equity investment is exchanged for control of the investee)?
Answer: An acquirer may transfer assets other than cash as part of the consideration transferred in a business combination. The difference between the fair value and the carrying value of the transferred asset is recognized as a gain or loss in earnings unless the assets remain in the combined group (ASC 805-30-30-8). See Section BCG 2.6.3.2 of PwC’s publication A Global Guide to Accounting for Business Combinations and Noncontrolling Interests, for further guidance. The tax consequences to the acquirer from transferring assets as part of consideration paid are recorded in the acquirer’s financial statements outside of acquisition accounting. However, sometimes the transfer is tax-free, in which case no income tax effect is recorded. Example 10-33 illustrates the income tax accounting for a transfer of an equity interest in exchange for control of a subsidiary and the transfer is tax-free.
Example 10-33: Income Tax Accounting for a Transfer of an Equity Interest in Exchange for Control of a Subsidiary and the Transfer is Tax-Free
Background/Facts:
Entity X owns 15 percent of Entity Y, which is a private entity. Entity X appropriately accounts for its investment by using the cost method. The two companies enter into an agreement whereby Entity Y exchanges a wholly owned subsidiary (Sub S) in return for Entity X’s 15 percent ownership interest in Entity Y.
Both the carrying value and the tax basis of Entity X’s investment in Entity Y is $300. The fair value is $1,000. The fair value of Sub S is less than the fair value of the Entity Y shares held by Entity X. Therefore, Entity Y infuses cash into Sub S just prior the exchange to equalise the value. After the cash infusion, the fair value of Sub S is $1,000. The fair value of Sub S’s identifiable assets and liabilities is $700. The tax bases of the assets and liabilities are equal to $500.
The exchange of Entity X’s investment in Entity Y for Entity Y’s investment in Sub S is tax-free. Entity X’s tax basis in its investment in Entity Y will become Entity X’s tax basis in its investment in Sub S. Assume that there is no uncertainty relative to the tax-free nature of the transaction.
After the transaction, Entity X will have the intent and ability to recover its investment in Sub S in a tax-free liquidation, and therefore will not record a DTL for any resulting book-over-tax outside basis difference in its investment in Sub S. Entity X’s tax rate is 40 percent.
Analysis/Conclusion:
Entity X recorded the following entries in acquisition accounting:
1 Fair value of the identifiable assets and liabilities of Sub S.
2 Goodwill is calculated as the residual after recording the identifiable net assets acquired and associated DTAs and DTLs ($1,000 – ($700 – $80)).
3 The DTL is calculated as the difference between the book bases of the identifiable net assets acquired and the carryover tax bases at the applicable tax rate (($700 – $500) x 40%).
4 The gain on investment is the difference between the fair value and the carrying value of Entity X’s investment in Entity Y ($1,000 – $300).
5 Carrying value of Entity X’s investment in Entity Y.
There is no tax consequence from exchanging Entity X’s investment in Entity Y for Entity Y’s investment in Sub S. Therefore, the gain from transferring the investment in Entity Y will impact Entity X’s effective tax rate.
Impact of Deferred Taxes on the Measurement and Presentation of Bargain Purchase Gains:
10.11.12 Question 12: How do deferred taxes related to acquired assets and liabilities impact the measurement and income statement presentation of the bargain purchase gain?
Answer: Deferred taxes are recognized as part of the acquired identifiable assets acquired and liabilities assumed. Therefore, the amount of the bargain purchase gain is directly affected by any such deferred taxes. However, like positive book goodwill, the bargain purchase gain is merely a residual for accounting purposes and generally would not be directly taxable. While not directly addressed in the Standards, we believe the gain should be presented on a single line in pretax income from continuing operations. The deferred taxes included in the determination of the bargain purchase gain should not be shown on the income tax line (i.e., the bargain purchase gain should not be grossed-up to exclude deferred taxes).
Transition Considerations
10.11.13 Question 13: How should excess tax-deductible goodwill from acquisitions made prior to the effective date of ASC 805 be accounted for?
Answer: In general, where specific transition guidance is not provided, companies should continue to follow the previous guidance for acquisitions consummated prior to the adoption of ASC 805.
Under historical U.S. GAAP guidance,3 if tax-deductible goodwill exceeded book goodwill as of the acquisition date, no deferred tax asset was recorded. The tax benefit of the excess tax basis is recognized when it is realized on the tax return. ASC 805 amended the guidance for accounting for excess tax-deductible goodwill at the acquisition date. However, no transition guidance was provided for accounting for excess tax-deductible goodwill that arose in acquisitions consummated prior to the effective date of ASC 805.
3 FAS 109, par. 263 prior to being amended by ASC 805-740.
Therefore, companies should continue to follow the historical guidance for recording the income tax benefit from amortizing component-2 tax-deductible goodwill for acquisitions consummated prior to the effective date of ASC 805. For those acquisitions, the tax benefit from the component-2 tax-deductible goodwill is recorded as the benefit is realized on the tax return, first as a reduction to goodwill from the acquisition, second as a reduction to other noncurrent intangible assets related to the acquisition, and third to reduce income tax expense. Example 10-34 illustrates the historical guidance for recording the income tax benefit from amortizing component-2 tax-deductible goodwill.
Example 10-34: Recording the Income Tax Benefit from Amortizing Component-2 Tax-deductible Goodwill for Acquisitions Consummated Prior to the Effective Date of ASC 805
Background/Facts:
As of the acquisition date, which was before the effective date of ASC 805, the book basis and tax basis of goodwill are $600 and $800, respectively. No deferred tax asset is recognized for the component-2 tax goodwill.
At the acquisition date, goodwill is separated into two components as follows:
For tax purposes, a goodwill amortization deduction of $400 is realized in each of years 1 and 2. For simplicity, the consequences of other temporary differences are ignored in this example. Income before income taxes in each of years 1 and 2 is $1,000. The tax rate is 40 percent for all years.
Analysis/Conclusion:
Income taxes payable for years 1 and 2 are:
The tax deduction from amortizing goodwill is taken pro rata from component-1 and component-2 goodwill. Therefore, component-1 goodwill is deductible $300 per year in years 1 and 2 (($600 / $800) x $400), providing a tax benefit of $120 ($300 x 40%) in each year. Component-2 goodwill is deductible $100 per year in years 1 and 2 (($200 / $800) x $400), providing a tax benefit of $40 ($100 x 40%) in each year.
The tax benefit from amortizing component-2 tax goodwill is recorded as a reduction to book goodwill when the deduction is realized on the tax return, creating a difference between the component-1 book and tax bases. Deferred taxes are provided for the difference that is created between the book and tax basis in component-1 goodwill, which is also recorded as a reduction to book goodwill. This reduction in book goodwill creates an additional deferred tax consequence. To address the iterative process, the computation of the total tax benefit related to component-2 goodwill amortization to record against goodwill can be reduced to the following equation:
(Tax Rate / (1 – Tax Rate)) x Realized Tax Benefit = Total Tax Benefit
(40% / (1 – 40%) x $100) = $67
The basis difference between the component-1 goodwill for years 1 and 2 are computed as follows:
1 Recording the $40 tax benefit as a reduction to goodwill creates a temporary difference for component-1 goodwill. The resulting deferred tax benefit is recorded as a reduction to goodwill, which again changes the temporary difference for component-1 goodwill. The benefit was calculated as follows: (40% / (1 – 40%)) x $40 = $27.
The deferred expense is a result of the change in the DTL each period. In year one, the DTL increased from zero to $93, resulting in a deferred tax expense of $93. Similarly, in year two, the DTL increased from $93 to $186, resulting in a deferred tax expense of $93.
Income tax expense for financial reporting for years 1 and 2 is:
2 The current and deferred tax expense is reported net of the current and deferred tax benefit from the goodwill amortization deduction. Therefore, an adjustment of $67 (current of $40 and deferred of $27) in each year is necessary to remove the benefits from income tax expense and record it as a reduction to goodwill.