11.2 General Principles of Income Tax Accounting for a Business Combination

Understanding the details of a business combination transaction is important to understanding the related impacts on income tax accounting. For example, depending on the nature of the transaction, certain elements may be accounted for as part of purchase accounting or as separate transactions in the postcombination financial statements of the acquirer or in the precombination financial statements of the acquiree.

11.2.1 Identifying Parts of the Business Combination

ASC 805-20-25-6 states:

At the acquisition date, the acquirer shall classify or designate the identifiable assets acquired and liabilities assumed as necessary to subsequently apply other GAAP. The acquirer shall make those classifications or designations on the basis of the contractual terms, economic conditions, its operating or accounting policies, and other pertinent conditions as they exist at the acquisition date.

Under ASC 805-20-25-6, DTAs and DTLs recognized in a business combination should reflect the tax attributes of the acquired entity as well as the structure of the combined entity as it exists on the acquisition date. Accordingly, the tax effects of income tax elections, changes in tax status, tax planning, and subsequent business integration steps that occur post-closing are generally accounted for separately and apart from the business combination (i.e., on “day 2”). However, some income tax elections, changes in tax status, tax planning, and subsequent business integration steps may be so integral to the business combination transaction that they should be included in the application of the acquisition method of accounting to the business combination.

While ASC 805-10-25-20 through 25-22 provide general guidance an entity should consider when determining whether a transaction is part of the business combination (see Section 1.1.9 of Deloitte’s Roadmap Business Combinations), there is no direct guidance addressing whether the tax effects of income tax elections, tax planning, and subsequent business integration steps that occur post-closing are so integral to the business combination transaction that they should be included in the acquisition accounting.

Accordingly, an entity must apply significant judgment on the basis of its facts and circumstances and should consider the following questions, which are neither mutually exclusive nor individually conclusive, when determining whether to include income tax elections, changes in tax status, tax planning, or other subsequent business integration steps that occur post-closing in its application of the acquisition method of accounting to the business combination.

Was the income tax election, change in tax status, tax planning, or subsequent business integration step a factor in the negotiations of the business combination (e.g., were any adjustments to the purchase price considered during negotiations with the previous owners in contemplation of, or as consideration for, any of the income tax elections, tax planning, or subsequent business integration steps), or was the income tax election, tax planning, or subsequent business integration step identified post-closing?
Was the effective date of the income tax election, tax planning, or subsequent business integration step concurrent with or retroactive to the acquisition date, or will it only become effective post-closing?
Was the income tax election, tax planning, or subsequent business integration step primarily within the control of the acquirer or seller, or were there uncertainties or regulatory hurdles related to the income tax election, tax planning, or business integration step as of the closing?
Would the income tax election, tax planning, or subsequent business integration step be expected of every market participant, or would it be based on the acquirer’s specific facts and circumstances?
Were the tax benefits of the income tax election, tax planning, or subsequent business integration step obtained without interaction with the government, or was the acquirer required to (1) make a separate payment directly to the governmental taxing authority or (2) forego tax attributes to obtain the tax benefits?

11.2.2 Change in Tax Status as a Result of Acquisition

An entity’s taxable status may change as a result of a business combination. For example, an S corporation could lose its nontaxable status when acquired by a C corporation. When an entity’s status changes from nontaxable to taxable, DTAs and DTLs should be recognized for any temporary differences in existence on the recognition date (unless one of the recognition exceptions in ASC 740-10-25-3 is applicable). Entities should initially measure such recognizable temporary differences in accordance with ASC 740-10-30. See Section 3.5.2 for further discussion of recognizing and measuring changes in tax status.

If the loss of the acquiree’s nontaxable status directly results from an acquisition, temporary differences in existence on the acquisition date should be recognized as part of the business combination acquisition accounting (i.e., through goodwill during the measurement period) under ASC 805-740-25-3 and 25-4. If, because of the acquisition, the acquired entity no longer meets the requirements to be considered a nontaxable entity, all the basis differences in the entity that would be considered taxable or deductible temporary differences would be recognized on the acquisition date. If a valuation allowance is established as part of the acquisition accounting (including amounts recorded as part of the measurement period), all subsequent changes to the valuation allowance are recorded in accordance with ASC 740, typically in income from continuing operations. See Section 11.5.1 for more information. Also see Section 3.5.2 for additional financial reporting considerations related to a change in tax status.

11.2.3 The Applicable Tax Rate

Because the combined entity and predecessor may have different tax characteristics, an entity must determine which tax rate to use to establish initial DTAs and DTLs when accounting for the tax impacts of a business combination.

ASC 740-10-30-5 states, in part, that “[d]eferred taxes shall be determined separately for each tax-paying component (an individual entity or group of entities that is consolidated for tax purposes) in each tax jurisdiction.” In addition, under ASC 740-10-30-8, an acquired entity’s deferred taxes should be measured by “using the enacted tax rate(s) expected to apply to taxable income in the periods in which the deferred tax liability or asset is expected to be settled or realized.”

If, in periods after the business combination, the combined entity expects to file a consolidated tax return, the enacted tax rates for the combined entity should be used in measuring the deferred taxes of the acquirer and the acquiree. The effect of tax law or rate changes that occur after the acquisition date should be reflected in income from continuing operations in the period in which the change in tax law or rate occurs (e.g., not as part of the business combination).

In some cases, the process of establishing the enacted rate(s) expected to apply is not straightforward. Among other situations, complexities arise during tax holidays and when an entity adds state jurisdictions to the acquirer’s state tax profile as a result of the acquisition.

11.2.3.1 Tax Holidays

Deferred taxes are not recognized for the expected taxable or deductible amounts of temporary differences that are related to assets or liabilities that are expected to be recovered or settled during a tax holiday. Paragraph 183 in the Basis for Conclusions of FASB Statement 109 states:

The Board considered whether a deferred tax asset ever should be recognized for the expected future reduction in taxes payable during a tax holiday. In most jurisdictions that have tax holidays, the tax holiday is “generally available” to any enterprise (within a class of enterprises) that chooses to avail itself of the holiday. The Board views that sort of exemption from taxation for a class of enterprises as creating a nontaxable status (somewhat analogous to S-corporation status under U.S. federal tax law) for which a deferred tax asset should not be recognized.

Therefore, deferred taxes are recognized for the expected taxable or deductible amounts of temporary differences that are expected to reverse outside of the tax holiday. In some situations, a temporary difference associated with a particular asset or liability may reverse during both the tax holiday and periods in which the entity is taxed at the enacted rates. Accordingly, it may be necessary to use scheduling to determine the appropriate deferred taxes to record in connection with the business combination.

For additional information on the effect of tax holidays on the applicable tax rate, see Section 3.3.4.5.

11.2.3.2 State Tax Footprint

The acquirer’s state tax footprint for an entity can change because of a business combination. For example, an acquirer that is operating in Nevada with no deferred state taxes but substantial temporary differences acquires a target company in California. As a result of this acquisition, the acquirer is now required to file a combined California tax return with the target company. Therefore, the acquirer must record deferred taxes for California state tax when no state taxes were previously recognized. When calculating the impact of this change on the state tax footprint, an entity must account for the income tax effects of its assets and liabilities before the combination separately from those that were acquired as part of the business combination.

Any change in the measurement of existing deferred tax items of the acquirer as a result of this acquisition are recorded “outside” of the acquisition accounting as a component of income tax expense. The initial recognition of deferred tax items of the target company by the acquirer is accounted for as part of the business combination.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.