11.3 Recognition and Measurement of Temporary Differences Related to Identifiable Assets Acquired and Liabilities Assumed

As noted in Section 11.1, the recognition principle and the measurement principle of ASC 805 require an entity to “recognize, separately from goodwill, the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree” and to measure “the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at their acquisition-date fair values.” These recognition and measurement principles may differ for financial reporting and tax purposes (i.e., an asset may be recorded at fair value for book purposes versus at carryover basis for tax purposes). In both taxable and nontaxable business combinations, DTAs and DTLs might need to be recorded for any deductible and taxable temporary differences (i.e., basis differences) that arise in connection with the accounting for the business combination or asset acquisition. The sections below discuss how to account for basis differences resulting from a business combination and provide examples of common scenarios in which additional considerations are necessary.

11.3.1 Basis Differences

A basis difference arises when there is a difference between the financial reporting amount of an asset or liability and its tax basis, as determined by reference to the relevant tax laws in each tax jurisdiction. There are two categories of basis differences: “inside” basis differences and “outside” basis differences. (For more information about inside and outside basis differences, see Section 3.3.1.)

The sections below describe the accounting for inside and outside basis differences that arise in a business combination.

11.3.1.1 Inside Basis Difference

An inside basis difference is a temporary difference between the carrying amount, for financial reporting purposes, of individual assets and liabilities and their tax bases that will give rise to a tax deduction or taxable income when the related asset is recovered or liability is settled. Deferred taxes are always recorded on taxable and deductible temporary differences unless one of the exceptions in ASC 740-10-25-3 applies.

11.3.1.2 Outside Basis Difference

An outside basis difference is the difference between the carrying amount of an entity’s investment (e.g., an investment in a consolidated subsidiary) for financial reporting purposes and the underlying tax basis in that investment (e.g., the tax basis in the subsidiary’s stock).

Deferred taxes are always recorded for taxable and deductible temporary differences unless a specific exception applies. The exception that may apply under ASC 740 depends on whether the outside basis difference results in a DTL or a DTA. DTLs are recorded on all outside basis differences that are taxable temporary differences unless one of the exceptions described in Section 3.3.2 is applicable. ASC 740-30-25-9 states that no DTAs should be recorded on the excess of tax over financial reporting basis in subsidiaries and corporate joint ventures unless it is “apparent that the temporary difference will reverse in the foreseeable future” (e.g., generally within the next 12 months).

Example 11-1

Inside Basis Difference

Assume the following:

Acquiring Company (AC) purchases Target Company’s (TC’s) stock for $1,000 in cash in a nontaxable business combination. TC meets the definition of a business under ASC 805.
TC has two subsidiaries (S1 and S2), each of which was acquired in a previous taxable stock acquisition.
S1’s and S2’s assets consist of buildings and equipment, which have fair values of $750 and $250, respectively.
All of the entities are domestic corporations with respect to AC.
The tax rate is 21 percent.

TC’s only assets are its shares of S1 and S2, as illustrated in the following table:

The journal entries recording the accounting for the initial acquisition are as follows:

To record AC’s investment in TC:

Note that while pushdown accounting is not required by ASC 805, journal entries have been recorded (i.e., pushed down) to the subsidiaries’ books because, in accordance with ASC 740-10-30-5, “[d]eferred taxes shall be determined separately for each tax-paying component . . . in each tax jurisdiction.” See Section 11.7.3 for further discussion.

Example 11-2

Outside Basis Difference

Assume the same facts as in Example 11-1. In addition to performing the inside basis difference assessment described in that example, Acquiring Company (AC) must determine whether there is a basis difference in its investment in Target Company (TC) and TC’s subsidiaries and whether that difference (if any) is a taxable temporary difference for which the establishment of a DTL would be required. If recorded, the DTL would adjust the goodwill recorded in Example 11-1 in connection with the business combination. The initial outside basis differences are as follows:

As illustrated in the table above, there is no difference between AC’s book and tax basis in its investment in TC for AC to assess as of the acquisition date. AC does, however, have differences to assess with respect to TC’s investment in S1 and S2. The following are two potential conclusions that AC could reach in assessing the outside basis difference:

Because S1 and S2 are domestic subsidiaries of AC, AC could determine that it would liquidate S1 and S2 into TC to eliminate the outside basis differences in a tax-free manner. Accordingly, in applying the provisions of ASC 740-30-25-7, AC could conclude that the outside basis differences in S1’s and S2’s stock are not temporary differences. See Section 3.4.3 for further discussion of a tax-free liquidation or merger of a subsidiary.
AC could determine that to dispose of S1 and S2, AC would choose to have TC sell their stock rather than sell their assets to maximize after-tax proceeds. Accordingly, the outside basis differences in S1’s and S2’s stock would both be taxable temporary differences and the DTLs would be recorded in the business combination accounting, which would affect the goodwill recorded in Example 11-1.

11.3.2 Goodwill

As previously noted, the acquisition method of accounting requires the acquirer to recognize and measure all separately identifiable assets and liabilities acquired or assumed in connection with a business combination. Even in a taxable business combination, there may be instances in which the financial statement carrying amount of goodwill differs from its tax basis. For example, certain intangibles are subsumed into goodwill for book purposes but are bifurcated into separate intangible assets for tax purposes, resulting in a basis difference in the goodwill and intangible assets. Conversely, book basis is allocated to some assets and liabilities in the acquisition that do not have tax basis (e.g., payment liabilities or lease assets and liabilities). In other instances, assets or liabilities may be valued differently for book and tax purposes (e.g., reacquired rights). Any of these scenarios could result in differences between the book basis and tax basis of goodwill.

As discussed further in Section 11.3.4, deferred taxes may need to be recorded as part of purchase accounting for these acquired assets and liabilities. For financial reporting purposes, the difference between the acquisition price and the fair value of the acquired assets and liabilities will be recorded as goodwill (or on rare occasions as a bargain purchase gain). A business combination may also result in an entity’s acquiring goodwill for tax purposes. Special accounting consideration (discussed further below) is required when an entity is determining how to account for the tax effects of acquired goodwill.

ASC 805-740

Goodwill

25-8 Guidance on the financial accounting for goodwill is provided in Subtopic 350-20. For tax purposes, amortization of goodwill is deductible in some tax jurisdictions. In those tax jurisdictions, the reported amount of goodwill and the tax basis of goodwill are each separated into two components as of the acquisition date for purposes of deferred tax calculations. The first component of each equals the lesser of goodwill for financial reporting or tax-deductible goodwill. The second component of each equals the remainder of each, that is, the remainder, if any, of goodwill for financial reporting or the remainder, if any, of tax-deductible goodwill.

25-9 Any difference that arises between the book and tax basis of that first component of goodwill in future years is a temporary difference for which a deferred tax liability or asset is recognized based on the requirements of Subtopic 740-10. If that second component is an excess of tax-deductible goodwill over the reported amount of goodwill, the tax benefit for that excess is a temporary difference for which a deferred tax asset is recognized based on the requirements of that Subtopic (see Example 4 [paragraph 805-740-55-9]). However, if that second component is an excess of goodwill for financial reporting over the tax-deductible amount of goodwill, no deferred taxes are recognized either at the acquisition date or in future years.

Related Implementation Guidance and Illustrations

Example 1: Nontaxable Business Combination [ASC 805-740-55-2].
Example 4: Tax Deductible Goodwill Exceeds Financial Reporting Goodwill [ASC 805-740-55-9].

ASC 805-740-25-3 indicates that recognition of deferred taxes on differences between the financial reporting and the tax basis of goodwill depends on whether goodwill amortization is deductible for tax purposes and on which approach an entity applies to determine whether amortization of goodwill is deductible for tax purposes. We are aware of two acceptable approaches in practice:

Approach 1 — Under this approach, for financial reporting purposes, deferred taxes generally should not be recognized for book and tax basis differences related to the portion of goodwill for which deductions are not allowed for the amortization or impairment of goodwill (e.g., goodwill subject to antichurning rules in the United States).
Approach 2 — Under this approach, deferred taxes could be recognized even if the goodwill amortization is not deductible for tax purposes as long as the tax basis in the goodwill would be deductible upon cessation or sale of a business with which it is associated. This view is based on ASC 740-10-25-50, which addresses the tax basis of an asset used in the determination of temporary differences.

In tax jurisdictions where goodwill is deductible, goodwill for financial reporting purposes and tax-deductible goodwill must be separated as of the acquisition date into two components, in accordance with ASC 805-740-25-8 and 25-9 (see illustration below).

The first component of goodwill (“component 1 goodwill”) equals the lesser of (1) goodwill for financial reporting purposes or (2) tax-deductible goodwill. Any difference that arises between the book and tax basis of component 1 goodwill in future periods is a temporary difference for which a DTA or DTL is recognized.

The second component of goodwill (“component 2 goodwill”) equals (1) total goodwill (the greater of financial reporting goodwill or tax-deductible goodwill) less (2) the calculated amount of component 1 goodwill.

If component 2 goodwill is an excess of tax-deductible goodwill over financial reporting goodwill, an entity must recognize a DTA related to the excess as of the acquisition date in accordance with ASC 740. The entity should use an iterative calculation to determine this DTA because goodwill and the DTA are established simultaneously as of the acquisition date. ASC 805-740-55-9 through 55-13 provide the “simultaneous equations method” for this purpose. Using this method, an entity simultaneously determines the amount of goodwill to record for financial reporting purposes and the amount of the DTA. The example below illustrates the application of the simultaneous equations method.

However, in accordance with ASC 805-740-25-9, if component 2 goodwill is an excess of financial reporting goodwill over tax-deductible goodwill, no DTL should be recorded.

Further, in certain business combinations, the acquired entity may have tax-deductible goodwill from a prior acquisition for which it received carry-over tax basis. The acquired tax-deductible goodwill should be included in the acquisition date allocation between component 1 goodwill and component 2 goodwill.

Example 11-3

Assume the following:

Acquisition date of January 1, 20X9.
Financial reporting goodwill of $800, before initial tax adjustments.
Tax goodwill of $1,000.
Annual tax amortization of $500 per year.
No other temporary differences.
Tax rate of 25 percent.
Income before taxes in year 1 is $10,000, in year 2 is $11,000, and in year 3 is $12,000.

On Acquisition Date:

Preliminary calculation of goodwill components:
Calculation of the DTA:
- DTA = [0.25 ÷ (1 – 0.25)] × $200.
- DTA = $67.
Journal entry to record the DTA:

Accounting in Years 1–3:

Calculation of taxes payable:
Calculation of deferred taxes:2

Goodwill is not amortized for financial reporting purposes. Each year, a DTL must be calculated and recognized for the difference between component 1 financial reporting goodwill and component 1 tax goodwill. This DTL will reverse when the company impairs, sells, or disposes of the related assets.
Realization of the tax benefit:

A tax benefit will be realized for the tax deduction associated with goodwill.

Journal Entries for Years 1 and 2:
P&L snapshot:

11.3.2.1 Pre-FASB Statement 141(R) Transactions

Given the long-term nature of goodwill balances, some goodwill may have been generated in connection with business combinations that were accounted for under FASB Statement 141 before the issuance of FASB Statement 141(R) (codified in ASC 805), which amended paragraph 262 of FASB Statement 109 to require that the tax benefit associated with component 2 tax-deductible goodwill (an excess of tax-deductible goodwill over financial reporting goodwill) be recognized as of the acquisition date. Before the amendments made by Statement 141(R), the tax benefit associated with component 2 tax-deductible goodwill was recognized only when realized on the tax return. This tax benefit was applied first to reduce goodwill related to the acquisition to zero, then to reduce other noncurrent intangible assets related to the acquisition to zero, and lastly to reduce income tax expense.

After the effective date of Statement 141(R) (codified in ASC 805), the tax benefit associated with component 2 tax-deductible goodwill should continue to be recognized when realized on the tax return for business combinations previously accounted for in accordance with FASB Statement 141 (i.e., business combinations consummated in periods before the effective date of Statement 141(R)).

Paragraph 77 of Statement 141(R) states, in part, “For business combinations in which the acquisition date was before the effective date of this Statement, the acquirer shall apply the requirements of Statement 109, as amended by this Statement, prospectively” (emphasis added). Therefore, an entity would still need to apply the guidance in paragraphs 262 and 263 of Statement 109 (before the Statement 141(R) amendments) to any component 2 tax-deductible goodwill from business combinations accounted for under Statement 141. That is, for business combinations consummated before the effective date of ASC 805 (Statement 141(R)), goodwill would continue to be adjusted as the tax benefit associated with component 2 goodwill is realized on the tax return. Paragraph 262 of Statement 109, before being amended by Statement 141(R), stated:

Amortization of goodwill is deductible for tax purposes in some tax jurisdictions. In those tax jurisdictions, the reported amount of goodwill and the tax basis of goodwill are each separated into two components as of the combination date for purposes of deferred tax calculations. The first component of each equals the lesser of (a) goodwill for financial reporting or (b) tax-deductible goodwill. The second component of each equals the remainder of each, that is, (1) the remainder, if any, of goodwill for financial reporting or (2) the remainder, if any, of tax-deductible goodwill. Any difference that arises between the book and tax basis of that first component of goodwill in future years is a temporary difference for which a deferred tax liability or asset is recognized based on the requirements of this Statement. No deferred taxes are recognized for the second component of goodwill. If that second component is an excess of tax-deductible goodwill over the reported amount of goodwill, the tax benefit for that excess is recognized when realized on the tax return, and that tax benefit is applied first to reduce to zero the goodwill related to that acquisition, second to reduce to zero other noncurrent intangible assets related to that acquisition, and third to reduce income tax expense.

Paragraph 263 of Statement 109, before being amended by Statement 141(R), included an example that illustrated the accounting for the tax consequences of goodwill when amortization of goodwill is deductible for tax purposes. The example below has been adapted from paragraph 263 of Statement 109 (as published before the amendments of Statement 141(R)) and illustrates the accounting that a reporting entity should apply to tax benefits associated with component 2 tax-deductible goodwill from business combinations originally accounted for under Statement 141. As described above, this accounting method applies even after the effective date of Statement 141(R).

Example 11-4

Assume the following:

As of the acquisition date (i.e., January 1, 20X8), the financial reporting amount and tax basis amount of goodwill are $600 and $800, respectively.
For tax purposes, amortization of goodwill will result in tax deductions of $400 in each of years 1 and 2. Those deductions result in current tax benefits in years 20X8 and 20X9.
For simplicity, the consequences of other temporary differences are ignored for years 20X8–2X11.
The entity has a calendar year-end and will adopt FASB Statement 141(R) on January 1, 20X9.
Income before income taxes is $1,000 in each of years 20X8–2X11.
The tax rate is 25 percent for all years.

Income taxes payable for years 20X8–2X11 are:

As of the combination date, goodwill is separated into two components as follows:

A DTL is recognized for the tax amortization of goodwill for years 20X8 and 20X9 for the excess of the financial reporting amount over the tax basis of the first component of goodwill. Although there is no difference between the book and tax basis of component 1 goodwill as of the business combination date (both $600), a difference does arise as of the reporting date. This difference results from (1) the reduction of book goodwill by the realized benefits on component 2 goodwill (the calculation is explained below) and (2) the tax amortization of the component 1 tax-deductible goodwill. When the second component of goodwill is realized on the tax return for years 20X8 and 20X9, the tax benefit is allocated to reduce financial reporting goodwill.

The second component of goodwill is deductible at $100 per year in years 20X8 and 20X9. Those tax deductions provide $25 ($100 at 25 percent) of tax benefits that are realized in years 20X8 and 20X9. The realized benefits reduce the first component of goodwill and produce a deferred tax benefit by reducing the taxable temporary difference related to that component of goodwill. Thus, the total tax benefit (TTB) allocated to reduce the first component of goodwill in years 20X8 and 20X9 is the sum of (1) the $25 realized tax benefit allocated to reduce goodwill and (2) the deferred tax benefit from reducing the DTL related to goodwill. The TTB is determined as follows:

TTB = realized tax benefit plus (tax rate times TTB)

TTB = $25 + (0.25 × TTB)

TTB = $33

Goodwill for financial reporting purposes for years 20X8–2X11 is:

The DTL for the first component of goodwill and the related amount of deferred tax expense (benefit) for years 20X8–2X11 are:

Income for financial reporting for years 20X8–2X11 is:

11.3.2.2 Amortization of Goodwill

As discussed in Section 11.3.2, in jurisdictions in which goodwill is deductible under the tax law, goodwill for financial reporting purposes and tax-deductible goodwill should be separated as of the acquisition date into two components in accordance with ASC 805-740-25-8 and 25-9. The first component of goodwill (“component 1 goodwill”) equals the lesser of (1) goodwill for financial reporting purposes or (2) tax-deductible goodwill. The second component of goodwill (“component 2 goodwill”) equals (1) total goodwill (the greater of financial reporting goodwill or tax-deductible goodwill) less (2) the calculated amount of component 1 goodwill.

When tax-deductible goodwill exceeds goodwill for financial reporting purposes, entities have alternatives for allocating tax amortization between component 1 goodwill and component 2 goodwill. However, these alternatives will have the same net effect on the consolidated financial statements.

The following two approaches are acceptable for allocating tax amortization between component 1 goodwill and component 2 goodwill:

Approach 1 — Allocate the tax amortization first to any amount of tax-deductible goodwill greater than goodwill for financial reporting purposes (i.e., allocate first to component 2 goodwill). Under this approach, the entity will first reduce any DTA recognized in the acquisition accounting before recognizing a DTL.
Approach 2 — Allocate the tax amortization on a pro rata basis between component 1 goodwill and component 2 goodwill. Under this approach, the entity will reduce the DTA recognized in the acquisition accounting for the tax amortization allocated to component 2 goodwill and at the same time recognize a DTL for the tax amortization allocated to component 1 goodwill.

The example below demonstrates the two approaches and their similar effects on the financial statements.

Example 11-5

Assume that Entity X acquires Entity Y in a taxable business combination. The acquisition results in goodwill for financial reporting purposes of $1 million and tax-deductible goodwill of $1.3 million. Entity X’s tax rate is 25 percent. Because tax-deductible goodwill exceeds goodwill for financial reporting purposes, X recognizes a DTA of $100,000 as part of the business combination accounting (see Section 11.3.2 for guidance on calculating this amount), with an offset to goodwill for financial reporting purposes (i.e., final goodwill for financial reporting purposes is $900,000 on the acquisition date). Assume for tax purposes that the tax-deductible goodwill is amortized over 10 years and that X has not recognized any goodwill impairments. In this example, component 1 goodwill would be $900,000 (i.e., the lesser of goodwill for financial reporting purposes and tax-deductible goodwill) and component 2 goodwill would be $400,000 (i.e., the difference between total tax-deductible goodwill of $1.3 million and component 1 goodwill of $900,000).

The following journal entries would be recorded to recognize the first year of tax amortization:

Approach 1 — The tax amortization of $130,000 ($1,300,000 ÷ 10 years) would be allocated to the component 2 goodwill. Therefore, component 2 goodwill would be reduced to $270,000 ($400,000 – $130,000) and the DTA recognized as of the acquisition date would be reduced by $32,500 ($130,000 × 25%).
Approach 2 — The tax amortization of $130,000 ($1,300,000 ÷ 10 years) would be allocated on a pro rata basis between the component 1 goodwill and the component 2 goodwill. Component 2 goodwill would be reduced to $360,000, which is calculated as $400,000 – ($400,000 ÷ $1,300,000 × $130,000), and the DTA associated with component 2 goodwill would be reduced by $10,000, or ($400,000 ÷ $1,300,000 × $130,000) × 25%. Component 1 goodwill would be reduced to $810,000, which is calculated as $900,000 – ($900,000 ÷ $1,300,000 × $130,000), which would create a DTL of $22,500, or ($900,000 ÷ $1,300,000 × $130,000) × 25%, for the taxable temporary difference between goodwill for financial reporting purposes and tax-deductible goodwill.

While amortization of the goodwill is reflected in both approaches, Approach 2 seemingly creates a DTL with the allocation. However, the goodwill remains one asset for financial reporting purposes and, correspondingly, the related deferred taxes should be considered on a net basis in the assessment of the need for a valuation allowance (i.e., the ending DTA in year 1 would be $67,500).

11.3.2.3 Private Company Alternative

The accounting for goodwill by a private company may differ from the accounting for goodwill by a public company. Under ASC 350-20-15-4, a private company may elect a simplified, alternative approach to subsequently account for goodwill (the “goodwill accounting alternative”). Under this approach, the company can amortize financial reporting goodwill related to each business combination on a straight-line basis, generally over a period of 10 years.

A private company that elects the goodwill accounting alternative should consider several things when preparing its provision for income taxes. Those considerations vary, in part, depending on whether the goodwill is deductible for tax purposes:

Non-tax-deductible goodwill — The accounting alternative does not change the prohibition on the recognition of a DTL for goodwill that is not deductible for tax purposes. The amortization of goodwill for financial reporting purposes will typically create a reconciling item related to the ETR (i.e., an unfavorable permanent difference).
Tax-deductible goodwill — The amortization of financial reporting goodwill will result in either an increase or a decrease to deferred taxes depending on how it compares with the related tax amortization in the period.

When both tax-deductible and non-tax-deductible goodwill are present, an entity must determine the amount of financial reporting goodwill amortization attributable to the components of goodwill that were originally determined in acquisition accounting. (See Section 11.3.2 for more information about the recognition of deferred taxes on the basis of the components of goodwill.) When an entity is determining the amount of financial reporting goodwill amortization attributable to the components of goodwill, it should consider whether it has already established a policy for such attribution in connection with a past impairment and, if so, should apply that policy consistently. One method that is commonly used in such circumstances is a pro rata allocation. (See the next section for an example illustrating a pro rata allocation.) Under a pro rata allocation approach for goodwill amortization, an entity would proportionally allocate the amortization to tax-deductible and nondeductible goodwill on the basis of the proportion of each. Other approaches may also be acceptable. Further complexities arise when the goodwill in a reporting unit is associated with multiple acquisitions or spans multiple taxing jurisdictions.

11.3.2.4 Impairment Testing

ASC 350-20 requires that goodwill be tested for impairment at least annually or between annual tests if certain events or circumstances occur. It further states that the “annual goodwill impairment test may be performed any time during the fiscal year provided the test is performed at the same time every year. Different reporting units may be tested for impairment at different times.” Entities should evaluate their own facts and circumstances in assessing whether to establish different reporting dates for different reporting units.

When tested, goodwill is tested for impairment at the reporting unit level. The ASC master glossary defines a reporting unit as “[t]he level of reporting at which goodwill is tested for impairment. A reporting unit is an operating segment or one level below an operating segment (also known as a component).”

Entities have the option to perform the qualitative assessment for a reporting unit to determine whether the quantitative impairment test is necessary. In evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, an entity should consider (1) the expected impact of the event or change in circumstances on the fair value of the reporting unit and (2) the amount by which fair value exceeds carrying value as of the date of the last impairment test. When the fair value of a reporting unit is only marginally higher than its carrying value, any expected decrease in the fair value of the reporting unit as a result of a subsequent event or change in circumstances should generally result in the conclusion that the entity needs to perform an impairment test.

Accordingly, an entity should perform its annual or interim goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. The entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized would not exceed the total amount of goodwill allocated to that reporting unit. In addition, an entity should consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable. ASC 350-20-35-8B states, in part, the following related to impairment of tax-deductible goodwill:

If a reporting unit has tax deductible goodwill, recognizing a goodwill impairment loss may cause a change in deferred taxes that results in the carrying amount of the reporting unit immediately exceeding its fair value upon recognition of the loss. In those circumstances, the entity shall calculate the impairment loss and associated deferred tax effect in a manner similar to that used in a business combination in accordance with the guidance in paragraphs 805-740-55-9 through 55-13. The total loss recognized shall not exceed the total amount of goodwill allocated to the reporting unit.

Application of the above guidance generally involves the use of the simultaneous equations method, as discussed in Section 11.3.2, to eliminate any excess carrying value attributable to the incremental DTA generated by the impairment charge. See additional discussion in Section 11.3.2.4.3 and Example 11-6 for an illustration of the application of this guidance. If, however, an entity has determined that a full valuation allowance is needed on the incremental DTA generated by an impairment charge for tax-deductible goodwill, application of the simultaneous equations method is not necessary because the impairment would not create any excess carrying value.

11.3.2.4.1 Assumptions Related to a Reporting Unit Bought or Sold in a Taxable or Nontaxable Business Combination

Determining the fair value of a reporting unit requires some assumptions about the sale of the reporting unit to a market participant. ASC 350-20-35-25 states that an entity’s assumption about whether a reporting unit would be bought or sold in a taxable or nontaxable business combination in its quantitative goodwill impairment test is a matter of judgment and will depend on facts and circumstances.

ASC 350-20-35-26 provides the following considerations to help entities make this determination:

Whether the assumption is consistent with those that marketplace participants would incorporate into their estimates of fair value
The feasibility of the assumed structure
Whether the assumed structure results in the highest and best use and would provide maximum value to the seller for the reporting unit, including consideration of related tax implications.

In addition, under ASC 350-20-35-27, an entity must also consider the following factors (not all-inclusive) when assessing whether it is appropriate to assume a nontaxable transaction:

Whether the reporting unit could be sold in a nontaxable transaction
Whether there are any income tax laws and regulations or other corporate governance requirements that could limit an entity’s ability to treat a sale of the unit as a nontaxable transaction.

11.3.2.4.2 Assigning Deferred Taxes to a Reporting Unit

When performing the quantitative goodwill impairment test, an entity should assign deferred taxes to its reporting units in determining their carrying value.

ASC 350-20-35-7 states that the deferred taxes related to the assets and liabilities of the reporting unit should be included in the carrying value of the reporting unit. This is true regardless of whether the entity assumes, in its determination of the fair value of the reporting unit, that the reporting unit would be bought or sold in a taxable or nontaxable business combination (see ASC 350-20-35-25 through 35-27). In determining whether to assign DTAs associated with NOL and tax credit carryforwards to a reporting unit, an entity should consider the following guidance from ASC 350-20-35-39 and 35-40:

35-39 For the purpose of testing goodwill for impairment, acquired assets and assumed liabilities shall be assigned to a reporting unit as of the acquisition date if both of the following criteria are met:

The asset will be employed in or the liability relates to the operations of a reporting unit.
The asset or liability will be considered in determining the fair value of the reporting unit.

Assets or liabilities that an entity considers part of its corporate assets or liabilities shall also be assigned to a reporting unit if both of the preceding criteria are met. Examples of corporate items that may meet those criteria and therefore would be assigned to a reporting unit are environmental liabilities that relate to an existing operating facility of the reporting unit and a pension obligation that would be included in the determination of the fair value of the reporting unit. This provision applies to assets acquired and liabilities assumed in a business combination and to those acquired or assumed individually or with a group of other assets.

35-40 Some assets or liabilities may be employed in or relate to the operations of multiple reporting units. The methodology used to determine the amount of those assets or liabilities to assign to a reporting unit shall be reasonable and supportable and shall be applied in a consistent manner. For example, assets and liabilities not directly related to a specific reporting unit, but from which the reporting unit benefits, could be assigned according to the benefit received by the different reporting units (or based on the relative fair values of the different reporting units). In the case of pension items, for example, a pro rata assignment based on payroll expense might be used. A reasonable allocation method may be very general. For use in making those assignments, the basis for and method of determining the fair value of the acquiree and other related factors (such as the underlying reasons for the acquisition and management’s expectations related to dilution, synergies, and other financial measurements) shall be documented at the acquisition date.

If an entity has recorded a valuation allowance pertaining to a DTA of a specific jurisdiction or character that has been allocated to a reporting unit, the associated valuation allowance would also be allocated to that reporting unit. An entity that files a consolidated tax return and has recorded a valuation allowance for DTAs at an entity (or jurisdiction) level should allocate the valuation allowance on the basis of the DTAs and DTLs of the entity (or jurisdiction) assigned to each reporting unit. While various methods of allocating such valuation allowance may be acceptable (e.g., assigning it on a pro rata basis to all affected DTAs or assigning it on the basis of which DTAs are more likely than not to be realized), entities should ensure that the method chosen results only in an actual allocation of the consolidated valuation allowance for the entity (or jurisdiction) (i.e., an entity should not perform an independent assessment of each reporting unit’s DTAs on a “separate return” basis because the assessment may or may not equal the consolidated totals for the entity [or jurisdiction]).

11.3.2.4.3 Determining the Deferred Tax Effects of a Goodwill Impairment

The initial accounting for an acquisition of a business is affected by whether the transaction is structured as a taxable or nontaxable transaction and whether the acquisition results in tax-deductible and nondeductible goodwill. (See Sections 11.1.3 and 11.3.2 for further discussion of the initial accounting in a business combination.) ASC 350-20-35-41 states, in part, that, for financial reporting purposes, “goodwill acquired in a business combination shall be assigned to one or more reporting units as of the acquisition date.”

ASC 350-20-35-1 states, in part, that “goodwill shall be tested at least annually for impairment at a level of reporting referred to as a reporting unit” (emphasis added). Under U.S. GAAP, a reporting unit is defined as “an operating segment or one level below an operating segment.”

However, ASC 740-10-30-5 states, in part, that “[d]eferred taxes shall be determined separately for each tax-paying component . . . in each tax jurisdiction.”

A reporting unit’s goodwill balance subject to impairment testing may comprise both tax-deductible and nondeductible goodwill. One common method used to allocate the goodwill impairment among the legal entities that constitute the reporting unit is pro rata allocation. Under this approach, an entity proportionately allocates the impairment to tax-deductible and nondeductible goodwill on the basis of the proportion of each in the reporting unit. Other approaches may also be acceptable; however, the approach an entity selects is an accounting policy election that, like all such elections, should be applied consistently.

The example below illustrates the application of the pro rata allocation approach, although we are aware of other approaches in practice. Note that this approach involves consolidated financial statements. When one or more of the legal entities within a reporting unit prepare separate-company financial statements, the allocations may differ between the separate and consolidated financial statements. Entities are encouraged to consult with their income tax accounting advisers when determining an appropriate approach.

Example 11-6

Tax-Deductible Goodwill

Background

Assume the following:

Company A has $1,500 of goodwill from an acquisition that is allocated to Reporting Unit RU.
All of the goodwill is tax deductible over 15 years.
The tax rate is 25 percent.
As of the date of the goodwill impairment test for RU:
- The tax basis of goodwill is $1,000, and RU has a DTL of $125.
- RU has a carrying value of $1,775, a fair value of $1,500, and a preliminary goodwill impairment of $275.

As a result of the change in deferred taxes related to the goodwill, RU has a carrying value of $1,569, which exceeds the fair value.

Assume that there is no book/tax difference on the other assets.

Analysis Under ASC 350-20-35-8B

The impairment loss is increased by $92, which is calculated by using the simultaneous equations method: 25% ÷ (1 – 25%) × 275 = 92. The additional impairment loss is offset by the deferred tax benefit.

Note that the total goodwill impairment of $367 can also be calculated as 275 ÷ (1 – 25%).

Tax-Deductible and Nondeductible Goodwill

Background

Assume the same facts as those above, except that Company A has $5,000 of goodwill from an acquisition that is allocated to Reporting Unit RU. Of this amount, $1,500 of the goodwill is tax deductible over 15 years.

In addition, assume the following:

On the date of the goodwill impairment test, RU has a carrying value of $5,300, a fair value of $4,300, and a preliminary goodwill impairment of $1,000.
RU has both tax deductible and nondeductible goodwill, and the pro rata approach is used to allocate goodwill impairment for deferred tax purposes (component 1 is 30% and component 2 is 70%).
Assume that there is no book/tax difference on the other assets.

Analysis Under ASC 350-20-35-8B

The impairment loss is increased by $81, which is calculated by using the simultaneous equations method: $1,000÷1 – (25% × 30%) = $1,081. The additional impairment loss is offset by the deferred tax benefit. Allocation of the total goodwill impairment between component 1 and 2 goodwill is as follows:

Component 1 impairment: $1,081 × 30% = $324.
Component 2 impairment: $1,081 × 70% = $757.

11.3.2.5 Disposal of Goodwill

In accordance with ASC 350-20, when all or a portion of a reporting unit that constitutes a business is disposed of, all or a portion of the goodwill allocated to that reporting unit needs to be included in the carrying amount of the reporting unit (or disposal group) when an entity is determining the gain or loss on disposal. Given the intricacies involved with determining the deferred tax accounting for goodwill (e.g., calculating component 1 and component 2 goodwill), additional complexities may arise when a reporting unit (or portion thereof) that has goodwill is disposed of.

An acquired business that generates goodwill will often be integrated into an existing reporting unit (or reporting units) of the acquirer. The reporting unit to which the assets and liabilities of the acquiree are assigned may be composed of multiple legal entities that were either acquired in previous business combinations or formed by the acquirer. Although the goodwill generated in the business combination will continue to be associated with the reporting unit to which it is allocated, the goodwill may not be specifically associated with the assets and liabilities from the business combination that generated the goodwill. For example, if an acquired business is significantly integrated with other subsidiaries of a reporting unit and a subsidiary within the reporting unit is subsequently disposed of, the acquirer may need to allocate a portion of the total goodwill of the reporting unit to the disposal group regardless of how the goodwill was generated.

Under ASC 350-20-40-3, an entity determines the amount of goodwill to be included in the carrying amount of the disposal group by allocating goodwill from the larger reporting unit to the part of the reporting unit being sold on the basis of relative fair value. However, for a reporting unit that contains goodwill that is tax deductible, ASC 350-20-40 does not provide guidance on how to determine what portion of the goodwill being disposed of represents component 1 goodwill and what portion represents component 2 goodwill. Further, because the allocation is made at the reporting unit level, the character of the goodwill to be included in the carrying amount of the disposal group (i.e., component 1 or component 2) will not always be determinable from the character of the goodwill recognized in the financial statements of the specific entity to be disposed of. Accordingly, several methods have developed in practice for determining the deferred tax consequences in these types of situations.

One such approach is the pro rata method, under which the character of the goodwill to be included in the carrying amount of the disposal group is determined on a pro rata basis by reference to the character of goodwill within the larger reporting unit.

A second approach is to determine the character of the goodwill to be retained by reference to the character of the goodwill of the component being disposed of, even though ASC 350-20-40-1 through 40-7 suggest that acquired goodwill loses its entity-specific character when an entity is performing an impairment test or determining the amount of goodwill to be allocated to a disposal group when part of a reporting unit is sold.

A third approach is to interpret ASC 350-20-40-1 through 40-7 as simply requiring the reporting entity to retain a portion of its investment in the disposed-of subsidiary within the reporting unit and then classify that portion as goodwill in its consolidated financial statements until the goodwill is recovered in accordance with ASC 350. Under this alternative, a DTL would be recorded because the residual outside basis difference would represent a taxable temporary difference for which no exception exists. The recognition of a DTL for the residual outside basis is also consistent with the fact that the corresponding tax basis in the “investment” is deducted upon the sale of the disposed-of entity’s stock for income tax purposes.

A fourth approach is to treat any goodwill retained by the reporting unit as a permanent difference (i.e., not a temporary difference). Under this approach, any goodwill remaining in the reporting unit is effectively characterized as internally generated goodwill that must be capitalized. Accordingly, ASC 740-10-25-3(d) would preclude the reporting entity from recognizing a DTL on goodwill retained for financial reporting purposes but not deductible for tax purposes. ASC 740-10-25-3(d) prohibits “recognition of a deferred tax liability [or asset] related to goodwill (or the portion thereof) for which amortization is not deductible for tax purposes.”

All of the approaches described above may be considered acceptable when a portion of the goodwill originally related to the component to be disposed of is retained. Regardless of the method selected, an entity should consistently apply its chosen approach to all dispositions of businesses within a reporting unit and provide adequate footnote disclosures that describe the accounting method used and the effects of applying that method.

While complexities are likely to be encountered when any of the approaches described above are applied, the second approach, in particular, will need to be supplemented by additional policies when the amount being allocated to the component being disposed of exceeds the amount recognized on the books of that specific component. Entities are encouraged to consult with their accounting advisers in these situations.

Note that each approach described above assumes that a subsidiary has been fully integrated into a reporting unit before disposal. If a subsidiary has not been previously integrated into a reporting unit, entities should apply ASC 350-20-40-4, which requires that the current carrying amount of the acquired goodwill (i.e., the actual subsidiary-specific goodwill) be included in the carrying amount of the subsidiary to be disposed of. In these types of situations, which are expected to be infrequent, entities are encouraged to consult with their accounting advisers.

The example below illustrates the methods described above applied to the disposal of goodwill.

Example 11-7

USP acquires 100 percent of the voting common stock of S1 for $1,000 in a nontaxable acquisition accounted for as a business combination. Accordingly, USP’s outside tax basis in the stock of S1 is $1,000. USP recognizes $100 of goodwill in the acquisition of S1. Since the transaction results in carryover tax basis, there is no corresponding tax basis in the goodwill (i.e., all goodwill is component 2 goodwill). USP assigns all the assets and liabilities of S1, including goodwill, to Reporting Unit 1.

As of the acquisition date of S1, Reporting Unit 1 consists of multiple legal entities, some of which were acquired and others of which were formed by USP. The goodwill recognized in these acquisitions and assigned to Reporting Unit 1 consists of a combination of tax-deductible and non-tax-deductible goodwill. When tax-deductible goodwill has been acquired, it has been amortized in accordance with tax law after the acquisition.

As of the acquisition date of S1, the GAAP and tax values of the goodwill are as follows:

Before the acquisition of S1, there is a $136.5 DTL associated with component 1 goodwill ((800 - 150) × 21%). After S1 is integrated into Reporting Unit 1, USP decides to sell S1 for consideration of $1,000. For simplicity, assume that the book basis in the assets of S1, exclusive of goodwill and related deferred taxes, if any, is $900 and there is no tax gain or loss on the sale. Assume that no goodwill impairments have been recognized under ASC 350 between the date of the acquisition of S1 and its disposition and there has been no amortization of the goodwill for financial or tax reporting purposes. Further assume that, in accordance with ASC 350-20-40-1 through 40-7, $70 of Reporting Unit 1 goodwill will be derecognized upon the sale of S1 and will affect the determination of the gain or loss on disposal for financial reporting purposes. Accordingly, upon the disposition of S1, only $70 of the goodwill recognized in connection with the acquisition of S1 will be derecognized, while $30 of the total goodwill recognized in connection with the acquisition of S1 will be retained as continuing goodwill of Reporting Unit 1.

Application of the Four Approaches

Derecognized Goodwill

Goodwill Remaining After Disposal

As shown above, the total goodwill remaining in Reporting Unit 1 is the same regardless of the approach used. The allocation between component 1 and component 2 goodwill under the different approaches is not constant.

Under approach 1, the reduction for the derecognized goodwill was allocated pro rata to Reporting Unit 1's component 1 and component 2 goodwill. As a result, there is a $4.7 reduction in the goodwill DTL (136.5 – [(777.6 – 150) × 21%]). Such reduction in DTL would be included as part of the disposal group, increasing the gain on the sale.

Under approach 2, all of the goodwill on S1's books is considered component 2, and the remaining $30 would still represent component 2 goodwill, resulting in no change to the recorded DTL.

Under approach 3, USP retains a portion of its investment in S1 within the reporting unit and classifies that portion as goodwill until the goodwill is recovered in accordance with ASC 350. A DTL would be recorded because the residual outside basis difference would represent a taxable temporary difference for which no exception exists. As a result, there is a $6.3 increase in the goodwill DTL ([830 – 150] × 21% – 136.5), resulting in a $6.3 increase to deferred tax expense.

Under approach 4, the $30 of goodwill remaining in Reporting Unit 1 is effectively characterized as internally generated goodwill that P must capitalize. Accordingly, ASC 740-10-25-3(d) precludes P from recognizing a DTL on goodwill retained for financial reporting purposes that is not deductible for tax purposes. As in approach 2 (in this fact pattern), there is no change to the goodwill DTL.

11.3.3 Bargain Purchase

In some limited situations, the fair value of assets acquired (net of assumed liabilities) exceeds the consideration paid to acquire the business. A bargain purchase occurs when the net of the fair value of the identifiable assets acquired and liabilities assumed exceeds the sum of:

The acquisition-date fair value of the consideration transferred, including the fair value of the acquirer’s previously held interest (if any) in the acquiree (i.e., a business combination achieved in stages).
The fair value of any noncontrolling interest in the acquiree.

These instances are expected to be infrequent and require an acquirer to reconsider whether all acquired assets have been separately recognized and properly measured. However, after the acquirer confirms that the fair value of acquired net assets exceeds the consideration paid, the acquirer recognizes the excess (i.e., the bargain purchase element) as a gain on the acquisition date.

When an entity has been acquired, the acquirer calculates the gain on the bargain purchase after the deferred taxes on the inside basis differences are recorded on the acquired entity’s assets and liabilities (see Section 11.3.1 for more information about inside and outside basis differences). The resulting bargain purchase gain recognized by the acquiring entity is recognized in earnings in accordance with ASC 805-30-25-2. Because the amount of the bargain purchase gain does not result in a step-up in the tax basis of the investment in the acquiree, a difference typically arises between the investment in the acquiree for financial reporting purposes and the investment in the acquiree for tax purposes. If deferred taxes are recorded on the outside basis difference caused by the bargain purchase gain, we believe that the corresponding tax effects would similarly be recorded in earnings as a component of income tax expense.

Example 11-8

Taxable Business Combination — Bargain Purchase

AC pays $800 to acquire TC, a domestic corporation, in a taxable business combination. The fair value of the identifiable assets is $1,000. AC recognizes a $158 gain on the bargain purchase. Assume a 21 percent tax rate.

For the inside basis difference, a DTL of $42 is recorded on the difference between the book basis ($1,000) and tax basis ($800) of the acquired assets.

The journal entries for the acquisition, gain on the bargain purchase, and resulting deferred taxes are as follows:

TC’s Journal Entry

AC’s Journal Entry

Regarding the outside basis difference, the carrying amount of AC’s investment in TC for financial reporting purposes will increase by $158 and there will be a corresponding increase in TC’s equity as a result of the recognition of the $158 gain.

The following table illustrates AC’s investment in TC:

In accordance with ASC 740-30-25-7, AC could determine that the outside basis difference in TC’s stock is not a taxable temporary difference because (1) the tax law provides a means by which the reported amount of that investment can be recovered tax free and (2) AC expects it will ultimately use that means. See Section 3.4.3 for further discussion of tax-free liquidation or merger of a subsidiary.

Example 11-9

Nontaxable Business Combination — No Bargain Purchase Gain Recognized as a Result of the DTL

AC pays $900 to acquire the stock of TC, a domestic corporation, in a nontaxable business combination. The fair value of the identifiable assets is $1,000. Assume that the tax bases of the identifiable assets are $400 and that the tax rate is 21 percent.

The following are TC’s and AC’s journal entries recording the acquisition and resulting deferred taxes:

TC’s Journal Entry

AC’s Journal Entry

The gain on the bargain purchase is calculated after deferred taxes are recorded. AC does not recognize a gain on the bargain purchase because the fair value of the identifiable assets acquired and liabilities assumed (net amount of $874) does not exceed the consideration transferred. There is no bargain purchase after the DTL is recorded for the difference between the book basis of $1,000 and tax basis of $400 for the assets acquired.

Example 11-10

Nontaxable Business Combination — Bargain Purchase

Assume the same facts as in the previous example except that the tax bases of the identifiable assets are $700 rather than $400.

A DTL of $63 is recorded for the difference between the book basis of $1,000 and tax basis of $700 for the assets acquired. The journal entries recording the acquisition gain on the bargain purchase and resulting deferred taxes are as follows:

TC’s Journal Entry

AC’s Journal Entry

These journal entries show that AC recognizes a $37 gain on the bargain purchase. As a result of AC’s recognition of a $37 gain, AC’s investment in TC will increase by $37, with a corresponding increase in TC’s equity. Thus, an outside basis difference will arise between the book basis of $937 and tax basis of $900 for TC’s stock. AC determines that the outside basis difference in TC’s stock is a taxable temporary difference and records a DTL.

AC’s Journal Entry

The DTL represents a $37 basis difference at a tax rate of 21 percent. Goodwill is not affected because the outside basis difference is related to the bargain purchase gain recognized and therefore is unrelated to the business combination accounting.

11.3.4 Other Assets Acquired

Although recognition and measurement of income taxes related to goodwill acquired in a business combination are considered among the most significant exceptions to the basic principles of acquisition accounting, special consideration must also be made for other types of assets acquired.

11.3.4.1 Other Intangibles

Deferred taxes are not recognized for differences between goodwill for financial statement purposes and nondeductible goodwill for tax purposes. However, deferred income taxes are always recognized for differences between the carrying amounts and tax bases of all acquired identifiable intangible assets (e.g., customer lists, trademarks, and core deposit intangibles of financial institutions), regardless of whether they are indefinite-lived or finite-lived. The FASB concluded that goodwill is a residual asset that is uniquely different from other types of long-term intangible assets that may not be deductible in certain tax jurisdictions. Therefore, the exception to recording deferred taxes on nondeductible goodwill is not carried over to indefinite-lived intangible assets.

11.3.4.2 Reacquired Rights

In a business combination, the acquirer may reacquire a right that it previously granted to the acquiree (e.g., a license or franchise). ASC 805-20-30-20 stipulates that reacquired rights are intangible assets that the acquirer must recognize apart from goodwill.

An acquirer measures the value of the reacquired right in a business combination in accordance with the fair value measurement guidance in ASC 820, with one exception: The value of the intangible asset is limited to its remaining contractual term (i.e., the contractual term that remains until the next renewal date), regardless of whether market participants would assume renewal or extension of the existing terms of the arrangement. Because renewals are not taken into consideration in the determination of the fair value, the reacquired right’s tax basis and its financial reporting basis as of the acquisition date will generally differ and a DTA should be recognized for the difference between the assigned value for financial reporting and tax purposes.

Subsequently, for financial reporting purposes, an entity must amortize the intangible assets related to reacquired rights on the basis of their remaining contractual terms. See the example below.

An acquiring entity must also determine whether the terms of the contract give rise to a reacquired right that is favorable or unfavorable in relation to similar market transactions for similar rights. If the terms of the contract do give rise to such a reacquired right, the acquirer recognizes a settlement gain or loss. ASC 805-10-55-21(b) provides guidance on calculating the settlement gain or loss, stating that it should be recorded as the lesser of:

The amount by which the contract is favorable or unfavorable from the perspective of the acquirer when compared with pricing for current market transactions for the same or similar items. . . .
The amount of any stated settlement provisions in the contract available to the counterparty to whom the contract is unfavorable. . . . [See Example 11-12.]

An acquirer may subsequently sell a reacquired right to a third party. The carrying amount of the recognized intangible asset (i.e., reacquired right) would then be included in the gain or loss on sale.

Example 11-11

Company B sells products in Europe under a license agreement with Company A. Company A acquires B for $100 million in a taxable business combination. As of the acquisition date, the license agreement has a remaining contractual term of three years and can be renewed at the end of the current term and indefinitely every five years thereafter. Assume that the pricing of the license agreement is at-market and that the agreement does not have explicit settlement provisions. The tax rate is 21 percent. Company A has calculated the following values for the license agreement:

$7.5 million — Value of the license for the remaining three-year contractual term.
$20 million — Fair value of the license agreement, calculated in accordance with the principles of ASC 820, which takes into account future renewals by market participants.
$60 million — Other tangible assets.

The following illustrates the book and tax bases of the assets:

In this example, A would recognize an intangible asset for $7.5 million and would amortize this amount over the remaining three-year contractual term for financial reporting purposes. Company A recognizes a DTA related to the license agreement’s tax-over-book basis of $2.625 million, or ($20 million – $7.5 million) × 21%. In accordance with ASC 805-740-25-3 and ASC 805-740-25-9, no DTL is recorded for the book-over-tax-basis goodwill of $9.875 million ($29.875 million – $20 million).

Example 11-12

Assume the same facts as in the example above, except that under the terms of the license agreement, Company B pays a license fee that is below-market in relation to that of its competitors with similar licensing agreements. In addition, Company A now calculates the value of the license, for the remaining three-year contractual term, to be $10 million. (Note that this amount is greater than the $7.5 million value calculated in the example above for an at-market contract, because the expense related to the license is less than the market rate.)

Company A would record an intangible asset of $7.5 million for the reacquired license (the at-market value for similar agreements) and would recognize a $2.5 million settlement loss in the income statement. In effect, the settlement loss represents additional consideration A would be required to give B to terminate the existing agreement, which was unfavorable to A.

The following illustrates the book and tax bases of the assets:

Company A recognizes a DTA related to the license agreement’s tax-over-book basis of $2.625 million, which is calculated as ($20 million – $7.5 million) × 21%, of which $2.1 million is a DTA recorded in the acquisition accounting (as a reduction to goodwill). The remaining component of the DTA of $525,000 is associated with the $2.5 million financial reporting loss ($2.5 million × 21%) that was recognized in the statement of operations by the acquirer (i.e., separately and apart from acquisition accounting). Therefore, in evaluating the DTA for realizability after the acquisition date, an entity should remember that the character of the DTA originated in part from a finite-lived intangible asset and in part from an expense recorded in the statement of operations.

In addition, ASC 805-740-25-3 and ASC 805-740-25-9 prohibit the recognition of a DTL for the book-over-tax-basis goodwill.

11.3.4.3 R&D Assets

Under ASC 350-30-35-17A, acquired R&D assets will be separately recognized and measured at their acquisition-date fair values. ASC 350-30-35-17A states that an R&D asset acquired in a business combination must be considered an indefinite-lived intangible asset until completion or abandonment of the associated R&D efforts. Once the R&D efforts are complete or abandoned, an entity should apply the guidance in ASC 350 to determine the useful life of the R&D assets and should amortize these assets accordingly in the financial statements. If the project is abandoned, the asset would be written off if it has no alternative use.

In accordance with ASC 740, deferred taxes should be recorded for temporary differences related to acquired R&D assets as of the business combination’s acquisition date. As with all acquired assets and assumed liabilities, an entity must compare the amount recorded for an R&D intangible asset with its tax basis to determine whether a temporary difference exists. If the tax basis of the R&D intangible asset is zero, as it will be in a typical nontaxable business combination, a DTL will be recorded for that basis difference. (See Section 5.3.1.3 for guidance on using these DTLs to evaluate DTAs for realization.)

11.3.4.4 Leveraged Leases Acquired

For accounting guidance on acquiring a leveraged lease in a business combination, see Section 4.3.11.14 of Deloitte’s Roadmap Business Combinations.

Under ASC 842-50-30-2, the initial recognition of a leveraged lease acquired in a business combination is unchanged from the guidance in ASC 840. That is, the acquiring entity should record an acquired leveraged lease on the basis of the remaining future cash flows while giving appropriate recognition to the estimated future tax effects of those cash flows.

Example 4 in ASC 842-50-55-27 through 55-33 illustrates the accounting for a leveraged lease acquired in a business combination.

For additional information about ASC 842, see Deloitte’s Roadmap Leases.

11.3.4.5 Obtaining Tax Basis Step-Up of Acquired Assets Through Direct Transaction With Governmental Taxing Authority

In some tax jurisdictions, an acquirer may pay the taxing authority to obtain a step-up in the tax basis of the net assets of the acquired business. Such a transaction is not with the acquiree and is not in exchange for the business acquired. Accordingly, the resulting step-up in tax basis should not be accounted for as part of the recording of deferred taxes under the acquisition method of accounting.

Rather, the acquisition of tax basis from the tax authority should be accounted for as a transaction that is separate and apart from the business combination in accordance with ASC 740-10-25-53. That guidance indicates that the deferred tax effects of a payment to a taxing authority to obtain a step-up in tax basis are generally accounted for directly in income (net of the amount of the payment). See ASC 740-10-55-202 through 55-204 for an example of such a transaction.

ASC 740-10-25-54 lists factors that may help an entity determine whether the step-up in tax basis is related to the business combination that caused the initial recognition of goodwill or to a separate transaction. If the step-up is related to the business combination in which the book goodwill was originally recognized, the entity would not record a DTA for the step-up in basis except to the extent that the newly deductible goodwill amount exceeds the remaining balance of book goodwill. If the step-up is related to a subsequent transaction, however, the entity would record a DTA. The factors in ASC 740-10-25-54 are not all-inclusive, however, and an entity must apply judgment when making this determination.

11.3.5 Liabilities Assumed

Recognition and measurement principles of certain liabilities assumed in a business combination may differ for financial reporting and tax purposes, resulting in deferred taxes. In addition, certain liabilities may be accounted for under exceptions to the general principles of ASC 805, requiring additional consideration when an entity is determining the appropriate tax accounting consequences.

11.3.5.1 Contingencies

Under ASC 805-20-25-19, a contingency should be recognized at its acquisition-date fair value if the acquisition-date fair value can be determined during the measurement period.

ASC 805-20-35-3 does not prescribe a specific method for measuring and accounting for contingencies after the acquisition date for financial reporting purposes; rather, it states that the acquirer should “develop a systematic and rational basis for subsequently measuring and accounting for . . . contingencies depending on their nature.” A contingency could result in a temporary difference on the acquisition date.

For tax purposes, the acquirer is generally precluded from recognizing a contingency until the contingency has become fixed and determinable with reasonable accuracy or, in some jurisdictions, until it has been settled. This could result in a basis difference between the assets and liabilities recognized for financial reporting and tax purposes on the acquisition date.

When assessing whether a DTA or DTL should be recognized on the acquisition date, the acquirer should determine the expected tax consequences that would result if the contingency was settled at its initial reported amount in the financial statements. In other words, the acquirer should determine the tax consequences as if the contingency was settled at the amount reported in the financial statements as of the acquisition date. The tax consequences will, in part, depend on how the business combination is structured for tax purposes (i.e., taxable or nontaxable business combination).

After the acquisition, the acquirer should account for the tax consequences resulting from a change in the fair value of an acquired contingency and recognize the deferred tax consequences of such change as a component of income tax expense (i.e., outside of the business combination), unless the change qualifies as a measurement-period adjustment under ASC 805-10-25-13.

11.3.5.1.1 Taxable Business Combination

11.3.5.1.1.1 Recognition and Initial Measurement

In a taxable business combination, the settlement of a contingency will generally affect the tax basis of goodwill. Therefore, the acquirer should assume that the contingency will be settled at its acquisition-date fair value and should include this amount in the calculation of tax-deductible goodwill when performing the acquisition-date comparison of tax-deductible goodwill with financial reporting goodwill. If the amount of the hypothetical tax-deductible goodwill (i.e., tax-deductible goodwill that includes the amount associated with the contingency) exceeds the amount of financial reporting goodwill, a DTA should be recorded. However, if the financial reporting goodwill continues to exceed the hypothetical tax-deductible goodwill, no DTL is recorded for the excess (because of the exception in ASC 805-740-25-9). See Section 11.3.2 for further discussion of the acquisition-date comparison of financial reporting goodwill with tax-deductible goodwill.

11.3.5.1.1.2 Subsequent Measurement

In a taxable business combination, a subsequent increase or decrease in the value of the contingency will result in an adjustment to the tax bases of the acquired assets. A DTA or DTL would be recorded through the tax provision for the expected tax consequences.

If the revised value exceeds the amount initially recorded as a liability, a DTA will be recorded in connection with expected additional tax-deductible goodwill. For financial reporting purposes, the additional tax-deductible goodwill is treated as unrelated to the acquisition (i.e., it is attributed to the expense recognized); therefore, a DTA results in the recording of a benefit to the acquirer’s income tax provision rather than a reduction in financial reporting goodwill.

If the contingency is settled for an amount less than the liability recorded on the books, there is a favorable adjustment to pretax book income. This pretax book income is eliminated from taxable income (e.g., by a Schedule M adjustment for U.S. federal tax). This adjustment to pretax book income is treated, in substance, as an accelerated deduction of component 1 amortizable goodwill (see Section 11.3.2 for a discussion of goodwill components). In this case, a DTL is recognized and the related income tax expense is recorded (see Example 11-13).

11.3.5.1.2 Nontaxable Business Combination

11.3.5.1.2.1 Recognition and Initial Measurement

In a nontaxable business combination, the settlement of a contingency may result in a tax deduction or taxable income (e.g., a legal dispute between an acquired entity and a third party is settled, resulting in a payment from the third party to the acquired entity). If the settlement of the contingency will result in either a tax deduction or taxable income, deferred taxes should be recorded as part of the acquisition accounting.

11.3.5.1.2.2 Subsequent Measurement

In a nontaxable business combination, if it was determined that the settlement of the contingency would result in either a tax deduction or taxable income, a subsequent change in the value of the contingency would result in a corresponding change to the previously recorded DTA or DTL. Any change recorded to either the DTA or DTL would be recognized as a component of income tax expense (i.e., outside of the business combination). See the example below.

Example 11-13

Taxable Business Combination

AC acquires the stock of TC for $45 million in a taxable business combination on June 30, 20X9 (e.g., a stock acquisition with a taxable election under IRC Section 338). In connection with the acquisition, AC recognizes a contingent liability at a fair value of $650,000. AC’s applicable tax rate is 25 percent.

The goodwill for financial reporting purposes is $4 million (including the fair value of the contingent liability). Tax-deductible goodwill is $3.5 million, excluding the fair value of the contingent liability.

For tax purposes, AC has determined that once the contingency is settled, it will be added to tax-deductible goodwill. Therefore, AC includes the acquisition-date fair value of the contingent liability in tax-deductible goodwill when comparing acquisition-date tax-deductible goodwill with financial reporting goodwill.

Tax-deductible goodwill is compared with financial reporting goodwill as follows:

Because hypothetical tax-deductible goodwill exceeds financial reporting goodwill, AC records a DTA by using the following iterative calculation, as described in Section 11.3.2:

DTA = [0.25 ÷ (1 – 0.25)] × $150,000

DTA = $50,000

June 30, 20X9

The following journal entries are recorded on June 30, 20X9:

TC (to reflect “push-down” of the journal entries to TC’s books)

September 30, 20X9

On September 30, 20X9, AC remeasures the contingent liability and determines its fair value to be $300,000, a decrease of $350,000 ($650,000 – $300,000). AC has determined that the adjustment to the contingent liability will decrease tax-deductible goodwill if settled at its adjusted financial reporting basis. Therefore, AC reduces the DTA recorded on the acquisition date and records a DTL. The acquisition-date comparison of financial reporting goodwill with tax-deductible goodwill should not be reperformed after the acquisition date.

The following journal entry is recorded on September 30, 20X9 (for simplicity, the effects of tax-deductible goodwill amortization are excluded from this example):

TC (to reflect “push-down” of the journal entries to TC’s books)

December 31, 20X9

On December 31, 20X9, AC settles the contingent liability for $1 million. The $700,000 increase in the obligation gives rise to an operating expense for financial reporting purposes and a deferred tax benefit of $175,000 ($700,000 × 25% tax rate). At settlement, AC adjusts its tax-deductible goodwill for the $1 million amount. Deferred taxes are adjusted accordingly.

The following journal entry is recorded on December 31, 20X9 (for simplicity, the effects of tax-deductible goodwill amortization are excluded from this example):

TC (to reflect “push-down” of the journal entries to TC’s books)

Example 11-14

Nontaxable Business Combinations

AC acquires the stock of TC for $45 million in a nontaxable business combination on June 30, 20X9. In connection with the acquisition, AC recognizes a contingent liability at a fair value of $650,000. The tax basis of the contingent liability is zero. For this example, assume that there are no differences between the carryover tax basis and book basis of the identifiable assets acquired. AC has determined that it will receive a tax deduction when the contingency is settled. AC’s applicable tax rate is 25 percent.

Because AC has determined that the contingent liability has a tax basis of zero and will result in a tax deduction when settled, a temporary difference exists.

June 30, 20X9

The following journal entries are recorded on June 30, 20X9:

TC (to reflect “push-down” of the journal entries to TC’s books)

September 30, 20X9

The following journal entry is recorded on September 30, 20X9:

TC (to reflect “push-down” of the journal entries to TC’s books)

December 31, 20X9

The following journal entry is recorded on December 31, 20X9:

TC (to reflect “push-down” of the journal entries to TC’s books)

11.3.5.2 Environmental Liabilities

A specific type of contingency that can be encountered as part of a business combination is an environmental remediation liability. There are unique tax considerations related to situations in which an acquirer purchases the assets of an entity that has preexisting contingent environmental liabilities. Presumably, the acquirer has factored the costs of any known remediation requirements into the amount that it would pay for the property when determining the property’s fair value in a business combination.

For financial reporting purposes, the asset requiring environmental remediation is recorded at fair value, full remediation is assumed, and a liability is recorded to recognize the estimated costs of remediation. However, for tax purposes, the asset is recorded at its unremediated value (the fair value less the estimated costs of remediation). Therefore, the acquirer will record a DTL for the taxable temporary difference between the amount recorded for financial reporting purposes and the tax basis of the asset.

Further, U.S. Treasury Regulation Section 1.338–5(b)(2)(iii) gives the following example illustrating when to adjust the tax basis for the contingent environmental liability:

T, an accrual basis taxpayer, is a chemical manufacturer. In Year 1, T is obligated to remediate environmental contamination at the site of one of its plants. Assume that all the events have occurred that establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy but economic performance has not occurred with respect to the liability within the meaning of section 461(h). P acquires all of the stock of T in Year 1 and makes a section 338 election for T. Assume that, if a corporation unrelated to T had actually purchased T’s assets and assumed T’s obligation to remediate the contamination, the corporation would not satisfy the economic performance requirements until Year 5. . . . The incurrence of the liability in Year 5 under the economic performance rules is an increase in the amount of liabilities properly taken into account in the basis and results in the redetermination of AGUB [adjusted grossed-up basis].

Therefore, in a taxable business combination, the settlement of a contingent environmental liability will generally increase tax-deductible goodwill. Therefore, as described in Section 11.3.5.1, the acquirer should assume that the contingent environmental liability will be settled at its acquisition-date fair value and should include this amount in the calculation of tax-deductible goodwill when performing the acquisition-date comparison with financial reporting goodwill. If the amount of the hypothetical tax-deductible goodwill (i.e., tax-deductible goodwill that includes the amount associated with the contingency) exceeds the amount of financial reporting goodwill, a DTA should be recorded. However, if the financial reporting goodwill exceeds the hypothetical tax-deductible goodwill, no DTL is recorded for the excess (because of the exception in ASC 805-740-25-9). See Section 11.3.2 for further discussion of the acquisition-date comparison of financial reporting goodwill with tax-deductible goodwill.

Example 11-15

AC acquires the stock of TC for $45 million in a taxable business combination on June 30, 20X9 (e.g., a stock acquisition with a taxable election under IRC Section 338). As part of the acquisition, AC recognizes a contingent environmental liability with a fair value of $1 million in connection with contaminated land. For financial reporting purposes, the land is recognized at its fair value (full remediation is assumed) of $5 million; however, for tax purposes, the land is recognized at only $4 million (i.e., the tax basis is based on unremediated fair value). The remaining assets of TC have a fair value of $37 million with an equal tax basis. AC’s applicable tax rate is 25 percent.

Goodwill for both financial reporting and tax purposes is calculated below:

AC will recognize a DTL of $250,000 for the taxable temporary difference between the tax basis of the land and the amount recorded for financial reporting purposes, or ($5,000,000 – $4,000,000) × 25%.

For tax purposes, AC has determined that once the contingent environmental liability is settled, it will be added to tax-deductible goodwill. Therefore, AC includes the acquisition-date fair value of the contingent environmental liability in tax-deductible goodwill when comparing acquisition-date tax-deductible goodwill with financial reporting goodwill.

Tax-deductible goodwill is compared with financial reporting goodwill as follows:

Because hypothetical tax-deductible goodwill exceeds financial reporting goodwill, AC records a DTA by using the following iterative calculation, as further described in Section 11.3.2:

DTA = [0.25 ÷ (1 – 0.25)] × $750,000

DTA = $250,000

June 30, 20X9

The following journal entries are recorded on June 30, 20X9:

TC (to reflect “push-down” of the journal entries to TC’s books)

11.3.6 Other Considerations

Other special considerations in connection with the recognition, measurement, and subsequent measurement of income taxes related to a business combination include those regarding transaction costs incurred, the settlement of preexisting relationships, assets that were previously subject to intra-entity sale guidance, and indemnification assets. As previously noted, it is important to fully understand the components of a business combination to appropriately apply the guidance.

11.3.6.1 Transaction Costs

Significant acquisition-related costs are often incurred in connection with a business combination, and the accounting for such costs may differ for financial and tax reporting purposes. To determine the appropriate accounting for acquisition-related costs, entities may need to also consider (among other factors) the timing of the expenditures (i.e., before or after the business combination is consummated) and which entity incurs the costs (i.e., the acquiree or the acquirer).

11.3.6.1.1 Transaction Costs Incurred by the Acquirer

In accordance with ASC 805-10, acquisition-related costs incurred by the acquirer in connection with a business combination (e.g., deal fees for attorneys, accountants, investment bankers, and valuation experts) must be expensed as incurred for financial reporting purposes unless they are subject to other U.S. GAAP (e.g., costs related to the issuance of debt or equity securities).

When acquisition-related costs are incurred, it may not be clear whether they will ultimately be deductible for income tax reporting purposes. For example, certain acquisition-related costs may have to be capitalized for income tax reporting purposes when incurred and become immediately deductible if the business combination is not consummated. If the business combination is consummated, the capitalized costs may be added (1) to the basis of the assets acquired in a taxable asset acquisition or (2) to the basis in the stock of the acquired entity in a nontaxable stock acquisition. Because acquisition-related costs are not considered part of the acquisition and are expensed as incurred for financial reporting purposes, the related deferred taxes (if any) will be recorded as a component of income tax expense (i.e., outside of the business combination). In addition, the portion of tax-deductible goodwill related to acquisition costs should not be included in the determination of component 1 and component 2 goodwill.

When acquisition-related costs are incurred in a period before a business combination is consummated and those costs are capitalized for tax purposes, a book/tax basis difference results. The acquirer will need to assess whether that basis difference represents a deductible temporary difference for which a DTA should be recorded. In making this determination, the acquirer may use either of the following two approaches.3

Approach 1 — If the costs that were capitalized for tax purposes will become deductible in the event the business combination does not occur, a deductible temporary difference exists, and a DTA should be recorded when the expense is recognized for financial reporting purposes. If the business combination is ultimately consummated, the acquirer would need to reassess the DTA to determine whether recognition continues to be appropriate. For example, if the business combination occurs and is a taxable asset acquisition, the capitalized costs would be added to the basis of the net assets acquired, and a DTA would generally result. Alternatively, if the business combination is consummated and is a nontaxable stock acquisition, the capitalized costs would be added to the basis of the stock acquired, and an outside basis deductible temporary difference would typically be created. However, the entity would need to evaluate whether an exception to recognition of the outside basis DTA is applicable (i.e., the entity would need to evaluate ASC 740-30-25-9). If recognition is no longer appropriate, the DTA should be reversed to the income statement.
Approach 2 — The acquirer can record a DTA if, on the basis of (1) the probability that the business combination will be consummated and (2) the expected tax structure of the business combination, the acquisition-related expenses would result in a future tax deduction. Approach 2 requires the acquirer, in determining whether to record all or a portion of the DTA for the acquisition expenses, to make assumptions about how the transaction would be structured from a tax perspective and about the probability that the business combination would be consummated. As a result of this approach, the entity would conform its financial reporting to its “expectation” as of each reporting date (i.e., the DTA may be recognized and subsequently derecognized if expectations change from one reporting period to the next).

11.3.6.1.2 Transaction Costs Incurred by the Target

Like acquisition-related costs incurred by the acquirer, precombination transaction costs incurred by the target are generally expensed as incurred for financial reporting purposes. It may not be clear at the time the costs are incurred whether they will ultimately be deductible for income tax reporting purposes. In some jurisdictions, capitalized transaction costs incurred by the target may result in a tax deduction (1) if the business combination is not consummated or (2) if the business combination is consummated and is treated as a taxable asset sale. However, if the business combination is consummated in the form of a nontaxable stock sale, the target’s capitalized transaction costs may not be deductible or amortizable.

When the target incurs precombination transaction costs and those costs are capitalized for tax purposes, the target will also need to assess whether that temporary difference is a deductible temporary difference for which a DTA should be recorded. We believe that the target may use either of the aforementioned approaches available to the acquirer to account for the expected tax consequences of the precombination transaction costs.

Example 11-16

Taxable Business Combination

AC acquires TC in a taxable business combination for $1,000 and incurs $200 of costs related to the acquisition. The identifiable assets have a fair value of $700. For financial reporting purposes, AC expenses the $200 of acquisition-related costs. For income tax reporting purposes, AC adds the $200 of acquisition-related costs to the total amount that is allocated to assets, resulting in tax-deductible goodwill of $500. Assume that the tax rate is 21 percent.

AC would record the following journal entries on the acquisition date:

The tax impact of the acquisition-related costs is reflected in the income statement because the excess amount of tax-deductible goodwill over financial reporting goodwill relates solely to the acquisition-related costs that are expensed for financial reporting purposes. As a result, neither (1) the acquisition-date comparison of tax-deductible goodwill with financial reporting goodwill nor (2) the iterative calculation described in ASC 805-740-25-8 and 25-9 and Section 11.3.2 is required.

Example 11-17

Nontaxable Business Combination

AC acquires TC in a nontaxable business combination for $1,000 and incurs $200 of costs related to the acquisition. The identifiable assets have a fair value of $700 and a tax basis of $250. For financial reporting purposes, AC expenses the $200 of acquisition-related costs. For tax purposes, AC adds the $200 of acquisition-related costs to the basis of TC’s stock. Assume a 21 percent tax rate.

AC would record the following journal entries on the acquisition date:

Unlike the acquisition-related expenses in the taxable business combination in Example 11-16, such expenses in the current example may not be tax-affected in a nontaxable business combination. The acquisition-related costs are included in the outside tax basis of AC’s investment in TC. Therefore, the DTA would have to be assessed in accordance with ASC 740-30-25-9. As long as it is not apparent that the temporary difference will reverse in the foreseeable future, no DTA is recorded.

11.3.6.2 Contingent Consideration

Many business combinations include contingent consideration features whereby the amount of consideration the buyer ultimately pays for the business will depend on the outcome of future events (for example, the earnings generated by the business for a period after the acquisition). ASC 805 requires the buyer to initially measure the contingent consideration at fair value and include the incurred liability as part of the purchase price for the acquired business. However, as discussed further below, there can be complexities regarding the initial and subsequent accounting for the tax impacts of contingent consideration.

11.3.6.2.1 The Income Tax Measurement Consequences of Contingent Consideration in a Business Combination

Differences exist between the accounting for contingent consideration in a business combination under U.S. GAAP and the tax treatment under the tax code. For financial reporting purposes, the acquirer is required to recognize contingent consideration as part of the consideration transferred in the business combination. The obligation is recorded at its acquisition-date fair value and classified as a liability or as equity depending on the nature of the consideration. The accounting consequences of the classification of contingent consideration are as follows:

Contingent consideration classified as equity is not remeasured.
Contingent consideration classified as a liability is remeasured at fair value on each reporting date. All post-measurement-period adjustments are recorded through earnings unless the arrangement is a hedging instrument under ASC 815, in which case the changes in fair value must be initially recognized in OCI (see ASC 805-30-35-1).

For tax purposes, however, the acquirer is generally precluded from recognizing contingent consideration as part of the consideration transferred until the contingency has become fixed and determinable with reasonable accuracy or, in some jurisdictions, until it has been settled. This could result in a difference in the total consideration recognized for financial reporting and tax purposes on the acquisition date.

To determine whether a DTA or DTL should be recognized on the acquisition date, the acquirer should determine the expected tax consequences that would result if the contingent consideration was settled at its initial reported amount in the financial statements as of the acquisition date. The tax consequences will, in part, depend on how the business combination is structured for tax purposes (i.e., as a taxable or nontaxable business combination).

11.3.6.2.1.1 Taxable Business Combination — Initial Measurement

In a taxable business combination, the settlement of contingent consideration will generally increase the tax basis of goodwill. The acquirer should assume that the contingency will be settled at its acquisition-date fair value and should include this amount in the calculation of tax-deductible goodwill when performing the acquisition-date comparison of tax-deductible goodwill with financial reporting goodwill. If the amount of the hypothetical tax-deductible goodwill (i.e., tax-deductible goodwill that includes the amount associated with the contingent consideration) exceeds the amount of financial reporting goodwill, a DTA should be recorded. However, if the financial reporting goodwill exceeds the hypothetical tax-deductible goodwill, no DTL is recorded for the excess (because of the exception in ASC 805-740-25-9). See Section 11.3.2 for further discussion of the acquisition-date comparison of financial reporting goodwill with tax-deductible goodwill.

11.3.6.2.1.2 Taxable Business Combination — Subsequent Measurement

A subsequent increase or decrease in the fair value of the contingent consideration liability will result in an adjustment to the hypothetical tax bases of the acquired assets. As a result, a book-to-tax basis difference may arise. A DTA or DTL would be recorded through the tax provision for the expected tax consequences of the change in the liability-classified contingent consideration.

If the revised fair value exceeds the amount originally recorded as a liability, a DTA will be recorded in connection with expected additional tax-deductible goodwill. For financial reporting purposes, this additional tax-deductible goodwill is treated as unrelated to the acquisition (i.e., it is considered to be newly arising after the business combination as a result of the expense recognized); therefore, the DTA results in recognition of a tax provision benefit to continuing operations rather than a reduction in financial reporting goodwill.

If the revised fair value is adjusted to an amount that is less than the liability originally recorded on the books, a DTL will be recorded to the extent that the adjustment results in a reduction to the hypothetical tax basis of component 1 goodwill. Component 1 goodwill is established on the acquisition date and not adjusted for subsequent changes to the fair value of the liability. Therefore, a DTL would be recognized for the difference between component 1 book goodwill and the revised hypothetical tax basis of component 1 goodwill (i.e., ASC 740-10-25-3(d) would not apply). See Section 11.3.2 for a discussion of goodwill components. For financial reporting purposes, this reduction to tax-deductible goodwill is also treated as unrelated to the acquisition; therefore, the DTL results in recognition of a tax provision expense to continuing operations rather than an adjustment to financial reporting goodwill (see Example 11-18).

Generally, any deferred tax consequences resulting from the resolution of equity-classified contingent consideration (i.e., changes in deferred taxes related to differences between the initial reported amount of equity-classified contingent consideration and the amount at settlement) are charged or credited directly to equity in accordance with ASC 740-20-45-11(g).

11.3.6.2.1.3 Nontaxable Business Combination — Initial Measurement

In a nontaxable business combination, the settlement of contingent consideration will generally increase the tax basis in the stock of the acquired company (i.e., it increases the outside tax basis; for more information about “inside” and “outside” basis differences, see Section 3.3.1). If the hypothetical tax basis in the shares (i.e., tax basis that includes the amount associated with the contingent consideration) exceeds the financial reporting basis of the shares acquired, the acquirer should consider the provisions of ASC 740-30-25-9 regarding the possible limitations on recognizing a DTA. However, if the financial reporting basis of the shares acquired exceeds the hypothetical tax basis, the acquirer should consider the provisions of ASC 740-10-25-3(a) and ASC 740-30-25-7 regarding the possible exceptions to recognizing a DTL. See Section 11.3.1.2 for further discussion of recognizing DTAs and DTLs related to outside basis differences.

11.3.6.2.1.4 Nontaxable Business Combination — Subsequent Measurement

In a nontaxable business combination, an increase or a decrease in the fair value of the contingent consideration for financial reporting purposes would result in an adjustment to the original hypothetical tax basis of the acquired company’s stock. In many cases, an exception to recording deferred taxes on outside basis differences will apply (e.g., see ASC 740-10-25-3(a) and ASC 740-30-25-7 and 25-8 for DTLs and ASC 740-30-25-9 for DTAs). See Example 11-19.

Example 11-18

Taxable Business Combination

AC acquires the stock of TC for $45 million and a contingent payment (classified as a liability) with a fair value of $5 million in a taxable business combination on June 30, 20X9 (e.g., a stock acquisition with a taxable election under IRC Section 338). The identifiable assets have a fair value of $45 million and an initial tax basis of $45 million. AC’s applicable tax rate is 21 percent.

June 30, 20X9

The following journal entries are recorded on June 30, 20X9:

TC (to reflect “push-down” of the journal entries to TC’s books)

AC determines that the expected tax consequences of settling the $5 million contingent consideration liability would be to increase the tax basis of its identifiable assets and goodwill to equal the book amounts. Therefore, no deferred taxes are recorded on the acquisition date because AC identifies no difference when performing the acquisition-date comparison of hypothetical tax-deductible goodwill with financial reporting goodwill.

September 30, 20X9

On September 30, 20X9, subsequent facts and circumstances indicate that the contingent consideration has a fair value of $3 million.

The $2 million decrease would reduce the hypothetical tax-deductible component 1 goodwill by $2 million. Accordingly, a $420,000 DTL is recognized ($2 million × 21%), with an offsetting journal entry to deferred tax expense.

December 31, 20X9

On December 31, 20X9, AC settles the contingent consideration for $11 million (fair value).

The $8 million increase gives rise to an equal amount of tax-deductible goodwill that corresponds to the $8 million pretax book expense. Accordingly, a $1.26 million DTA is recognized along with a decrease of the $420,000 DTL that was recognized on September 30, 20X9. The offsetting journal entry is to recognize deferred tax expense of $1.68 million.

Example 11-19

Nontaxable Business Combination

AC acquires the stock of TC for $45 million and a contingent payment (classified as a liability) with a fair value of $5 million in a nontaxable business combination on June 30, 20X9. The identifiable assets have a fair value of $45 million and a carryover tax basis of $45 million. AC’s applicable tax rate is 21 percent.

June 30, 20X9

The following journal entries are recorded on June 30, 20X9:

TC (to reflect “push-down” of the journal entries to TC’s books)

AC determines that the expected tax consequences of settling the $5 million contingent liability would be to increase the tax basis of its investment in TC. As demonstrated below, after considering the future tax consequences of settling the contingent consideration liability, there is no difference between the book basis and the hypothetical tax basis of its investment in TC, so no deferred taxes are recorded on the acquisition date.

However, if, after the contingent liability is considered, the hypothetical tax basis had exceeded the book basis, AC would have needed to consider ASC 740-30-25-9 before recognizing a DTA on the outside basis difference. If, after the contingent consideration liability is considered, the hypothetical tax basis had still been less than the book basis, AC would have needed to consider ASC 740-10-25-3(a) and ASC 740-30-25-7 before recognizing a DTL on the outside basis difference.

September 30, 20X9

On September 30, 20X9, subsequent facts and circumstances indicate that the contingent consideration has a fair value of $3 million.

Because the future settlement of the contingent consideration will affect the outside tax basis of the shares, AC considers ASC 740-10-25-3(a) and ASC 740-30-25-7 and concludes that no associated DTL should be recorded. Therefore, there is book income without a corresponding tax expense, resulting in an impact to the ETR.

December 31, 20X9

On December 31, 20X9, AC settles the contingent consideration for $11 million (fair value).

Because the settlement of the contingent consideration affects the outside tax basis of the shares, AC considers ASC 740-30-25-9 and concludes that no associated DTA should be recorded. Therefore, there is book expense without a corresponding tax benefit, resulting in an impact to the ETR.

11.3.6.3 Business Combinations Achieved in Stages

A business combination is achieved in stages when an acquirer holds a noncontrolling interest in an investment (e.g., an equity method investment) in the acquired entity (the “original investment”) before obtaining control of the acquired entity. When the acquirer obtains control of the acquired entity, it remeasures the original investment at fair value. The acquirer adds the fair value of the original investment to the total amount of consideration transferred in the business combination (along with the fair value of any noncontrolling interest still held by third parties) to determine the target’s opening equity (which in turn affects the measurement of goodwill). The gain or loss resulting from the fair value remeasurement is reported in the statement of operations (separately and apart from the acquisition accounting). Any gains or losses previously recognized in OCI that are associated with the original investment are reclassified and included in the calculation of the gain or loss.

For the acquirer, the remeasurement of the original investment in a business combination achieved in stages at fair value will result in an increase or a decrease in the financial reporting basis of the investment. Generally, the tax basis of the investment will not be affected, and an outside basis difference will therefore be created. (For further guidance on outside basis differences, see Section 3.3.1.)

11.3.6.3.1 DTLs for Domestic Subsidiaries Acquired in Stages

If the acquiree is a domestic subsidiary, the acquirer may not be required to recognize a DTL for an outside basis difference once the acquirer obtains control of the acquiree. ASC 740-30-25-7 states that the acquirer should assess whether the outside basis difference of an investment in a domestic subsidiary is a taxable temporary difference. If the tax law provides a means by which the tax basis of the investment can be recovered in a tax-free transaction and the acquirer expects that it will ultimately use that means to recover its investment, a DTL should not be recognized for the outside basis difference. Therefore, under these circumstances, the acquiring entity should reverse any DTL previously recognized for the outside basis difference, including any DTL associated with the remeasurement of the original investment. This reversal of the DTL should be recognized in the acquirer’s statement of operations in the same period that includes the business combination.

The gain or loss resulting from the remeasurement of the original investment at fair value is reported in the statement of operations (separately and apart from the acquisition accounting). The corresponding tax effect of the remeasurement should also be recorded as a component of the income tax provision unless an exception applies (e.g., ASC 740-30-25-9, ASC 740-10-25-3, or ASC 740-30-25-7). See the example below.

Example 11-20

In year 1, AC purchased 20 percent of TC, a domestic investee, for $100. In year 2, AC records $100 of equity method earnings. Accordingly, at the end of year 2, AC has a $200 book basis and $100 tax basis in its equity method investment and records a DTL of $21 on the outside basis difference. Assume that the tax rate is 21 percent.

AC’s journal entries are as follows:

Year 1

Year 2

In a nontaxable business combination, AC purchases the remaining 80 percent of TC for $2,000. The fair value of all the identifiable assets is $2,000, and their tax basis is $500.

AC remeasures its 20 percent investment in TC as $500 (for simplicity, any control premium is ignored) and recognizes $300 of gain.

AC records the following journal entries for the remeasurement of its original investment in TC:

AC records a DTL on the remeasurement gain because it determines that the outside basis difference is a taxable temporary difference (i.e., the exception in ASC 740-30-25-7 does not apply).

AC records the following journal entries for the acquisition and resulting deferred taxes:

TC (to reflect “push-down” of the journal entries to TC’s books)

A DTL of $315 is recorded on the inside basis difference attributable to the asset acquired, since the book basis of the assets acquired is greater than the tax basis ($2,000 – $500). No DTL is recorded on the book-greater-than-tax basis ($815 – $0) in goodwill, in accordance with ASC 805-740-25-9.

If, at any time after the acquisition, AC (1) reassesses the outside basis difference in its investment in TC and concludes that the tax law provides a means by which the reported amount of its investment can be recovered tax free, and (2) expects that it will ultimately use that means, the DTL on the outside basis difference would be reversed as an adjustment to income tax expense.

Example 11-21

Assume the same facts as in the example above, except that in applying ASC 740-30-25-7, AC determines that its outside basis difference in TC is not a taxable temporary difference and therefore records no deferred taxes.

AC records the following journal entries for the remeasurement of its original investment in TC:

Because AC determines that its outside basis difference in TC (a domestic investee) is not a taxable temporary difference under ASC 740-30-25-7, AC reverses the previously recorded DTL for the outside basis difference, which is calculated as ($200 book basis – $100 tax basis) × 21% tax rate, and records no DTL for the outside basis difference created from the remeasurement gain.

AC records the following journal entries for the acquisition and resulting deferred taxes:

TC (to Reflect “Pushdown” of the Journal Entries to TC’s Books)

A DTL of $315, or ($2,000 – $500) × 21%, is still recorded on the inside basis difference of the assets acquired, since the exception in ASC 740-30-25-7 is related only to the outside basis differences.

If TC were a partnership for U.S. tax purposes and AC purchased its interest via a separate subsidiary so that TC’s partnership status postacquisition was preserved, the exception in ASC 740-30-25-7 would generally not apply because an investor in a flow-through entity typically cannot recover its investment in a tax-free manner. Rather, the outside basis difference would reverse through normal operations and would therefore be a taxable temporary difference. In addition, deferred taxes would not be recorded on the underlying assets inside TC since TC is a nontaxable entity.

11.3.6.4 Accounting for the Settlement of a Preexisting Relationship

If a business combination effectively results in the settlement of a preexisting relationship between an acquirer and an acquiree, the acquirer would recognize a gain or loss. ASC 805-10-55-21 indicates how such a gain or loss should be measured:

For a preexisting noncontractual relationship, such as a lawsuit, fair value
For a preexisting contractual relationship, the lesser of the following:
1. The amount by which the contract is favorable or unfavorable from the perspective of the acquirer when compared with pricing for current market transactions for the same or similar items. An unfavorable contract is a contract that is unfavorable in terms of current market terms. It is not necessarily a loss contract in which the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it.
2. The amount of any stated settlement provisions in the contract available to the counterparty to whom the contract is unfavorable. If this amount is less than the amount in (b)(1), the difference is included as part of the business combination accounting.

Note that if a preexisting contract is otherwise cancelable without penalty, no settlement gain or loss would be recognized. The acquirer’s recognition of an asset or liability related to the relationship before the business combination will affect the calculation of the settlement (see the example below).

When a business combination results in the settlement of a noncontractual relationship, such as a lawsuit or threatened litigation, the gain or loss should be recognized and measured at fair value. This settlement gain or loss may differ from any amount previously recorded under the contingency guidance in ASC 450.

The examples below have been adapted from ASC 805-10-55-30 through 55-32 to illustrate the tax effects of a preexisting relationship between parties to a business combination.

Example 11-22

AC acquires TC in a taxable business combination. The acquisition includes a supply contract under which AC purchases electronic components from TC at fixed rates over a five-year period. Currently, the fixed rates are higher than the rates at which AC could purchase similar electronic components from another supplier. The supply contract allows AC to terminate the contract before the end of the initial five-year term only by paying a $6 million penalty. With three years remaining under the supply contract, AC pays $50 million to acquire TC.

This amount is the fair value of TC and is based on what other market participants would be willing to pay for the entity (inclusive of the above-market contract). The total fair value of TC includes $8 million related to the fair value of the supply contract with AC. The $8 million represents a $3 million component that is “at-market” because the pricing is comparable to pricing for current market transactions for the same or similar items (e.g., selling effort, customer relationships) and a $5 million component for pricing that is unfavorable to AC because it exceeds the price of current market transactions for similar items. TC has no other identifiable assets or liabilities that are related to the supply contract, and AC has not recognized any assets or liabilities in connection with the supply contract before the business combination. The remaining fair value of $42 million relates to machine equipment. The tax rate is 21 percent. Assume a taxable transaction in a jurisdiction that allows for tax-deductible goodwill.

AC will record the following journal entries on the acquisition date:

In applying ASC 805-10-55-21(b), AC recognizes a loss of $5 million (the lesser of the $6 million stated settlement amount in the supply contract or the amount by which the contract is unfavorable to the acquirer) separately from the business combination. The $3 million at-market component of the contract is part of goodwill.

The $5 million loss on the supply contract is recognized as an expense in the statement of operations for financial reporting purposes (e.g., separately and apart from the acquisition accounting). Typically, the supply contract will not be viewed as a separate transaction for tax purposes and will be included in tax-deductible goodwill, resulting in a temporary difference. This will give rise to a DTA and a tax provision credit as a result of tax affecting the $5 million loss recognized in the statement of operations. The resulting DTA would be reversed when the goodwill is deducted on the tax return (as long as there are no realization concerns).

Note that if this transaction was structured as a nontaxable business combination (i.e., AC acquires the stock of TC), the basis difference that arises related to the $5 million loss would not give rise to a DTA as discussed in the preceding paragraph (i.e., because it would now be related to an excess tax over financial reporting basis in a subsidiary and be subject to the exception in ASC 740-30-25-9).

Example 11-23

Assume the same facts as in the example above (e.g., a taxable business combination and tax-deductible goodwill), except that AC had recorded a $6 million liability and a $1.26 million DTA related to the supply contract with TC before the business combination.

AC will record the following journal entries on the acquisition date:

In applying ASC 805-10-55-21(b), AC recognizes a $1 million settlement gain on the contract (the $5 million measured loss on the contract less the $6 million loss previously recognized), along with the corresponding tax effects, separately from the business combination. The $3 million at-market component of the contract is part of goodwill.

Because the transaction is structured as a taxable business combination, the tax impact on the total $5 million loss related to the supply contract is treated the same as in the example above (i.e., the supply contract will not be viewed as a separate transaction for tax purposes and will be included in tax-deductible goodwill, resulting in a temporary difference and corresponding DTA and tax provision credit).

11.3.6.5 Recognition of Changes in Indemnification Assets Under a Tax Indemnification Arrangement

Business combinations commonly involve tax indemnification arrangements between the former parent and the acquirer of a subsidiary in which the parent partly or fully indemnifies the acquirer for tax uncertainties related to uncertain tax positions taken by the subsidiary in periods before the sale of the subsidiary.

ASC 805 addresses the accounting for indemnifications in a business combination. Specifically, ASC 805-20-25-27 states, in part, 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 the need for a valuation allowance for uncollectible amounts.” ASC 805-20-30-19 further elaborates on indemnifications provided for uncertain tax positions:

[A]n indemnification may relate to an asset or a liability, for example, one that results from an uncertain tax position that is measured on a basis other than acquisition-date fair value. . . . [I]n those circumstances, the indemnification asset shall be recognized and measured using assumptions consistent with those used to measure the indemnified item, subject to management’s assessment of the collectibility of the indemnification asset and any contractual limitations on the indemnified amount.

Therefore, if the subsidiary (after the acquisition) has UTBs determined in accordance with ASC 740 and if the related tax positions are indemnified by the former parent, the acquirer (or potentially the subsidiary itself if it is the legal counterparty to the indemnification agreement) could recognize an indemnification asset on the basis of the indemnification agreement and the guidance in ASC 805-20-25-27 and ASC 805-20-30-19. The guidance in ASC 805-20-35-4 also addresses the subsequent measurement of indemnification assets.

Example 11-244

Company P sells its subsidiary (Company S) to an unrelated party in January 20X9. Before the sale, P and S were separate companies and filed separate income tax returns. In connection with the sale, P and S enter into an indemnification agreement in which P will partially indemnify S for the settlement of S’s uncertain tax positions related to periods before the sale (i.e., P and S will share 40 percent and 60 percent of the settlement, respectively). Specifically, if S settles an uncertain tax position with the tax authority for $100, S would be reimbursed $40 by P. However, S remains the primary obligor for its tax positions since it filed separate returns before the sale.

Assume that, upon the sale, S has recorded a liability of $100 for UTBs. On the basis of its specific facts and circumstances, S determines that recording a receivable (i.e., an indemnification asset) for the indemnification agreement is appropriate in accordance with ASC 805. At the time of the acquisition and subsequently, S concluded that, in the absence of collectibility concerns, the indemnification receivable should be accounted for under the same accounting model as that used for the related liability and subsequently adjusted for any changes in the liability. Company S also concluded that the indemnification receivable should not be recorded net of the related UTBs because it does not meet the criteria for offsetting in ASC 210-20. (See Section 2.8 for an example illustrating the accounting for the guarantor side of the indemnification agreement.) Therefore, at the time of the acquisition, S recorded an indemnification receivable (an “indemnification asset”) of $40, which equals the amount that it expects to recover from P as a result of the indemnification agreement.

The potential payments to be received under the indemnification agreement are not income-tax-related items because the amounts are not due to or from a tax jurisdiction. Rather, they constitute a contractual agreement between the two parties regarding each party’s ultimate tax obligations. If S settled its uncertain tax positions with the tax authority, and P was unable to pay S the amount due under the indemnification agreement, S’s liability to the tax authority would not be altered or removed.

SEC Regulation S-X, Rule 5-03(b)(11),5 notes that a company should include “only taxes based on income” in the income statement line item under the caption “income tax expense.” Accordingly, any adjustment to the indemnification asset should be included in an “above the line” income statement line item. If S determined that P was unable to pay its $40 obligation, S would impair the indemnification asset and record the associated expense outside of “income tax expense.”

Similar issues may arise when a subsidiary is spun off from its parent. See Section 4.6.6 for considerations involving UTBs in a spin-off transaction.

For additional considerations related to income tax indemnifications upon the sale of a subsidiary that previously filed a separate tax return, meaning that the acquiring entity may not be directly liable for the acquiree’s tax obligations upon acquisition, see Section 2.8.

11.3.6.6 Acquired Current Taxes Payable

In general, acquired liabilities are recorded at fair value on the acquisition date as prescribed under ASC 805-20-25-1. However, this requirement only applies to liabilities that exist as of the acquisition date.

In some business combinations, income taxes are due as a result of a requirement to prepare a stub-period tax return for the acquired entity. Those income taxes payable would be included as a liability acquired by the acquirer and recorded in purchase accounting. After the acquisition, any tax on income generated would not be included as a liability assumed by the acquirer and would be recorded as a component of postacquisition income tax expense.

11.3.6.7 GILTI Considerations in a Business Combination

As discussed in Section 3.4.10, GILTI earned by a CFC must be included currently in the gross income of the CFC’s U.S. shareholder. Under U.S. tax law, GILTI is recognized by the U.S. shareholder on the last day of the CFC’s tax year. Furthermore, a CFC’s tax year, for U.S. purposes, may not end as a result of an acquisition of its U.S. shareholder. Therefore, an acquirer of a CFC may be obligated to pay tax under the GILTI regime on income earned by an acquired entity before the acquisition. For example, if a U.S. entity (the acquirer) acquires another U.S. entity (the target) that wholly owns a foreign subsidiary (the CFC) and the target immediately joins the acquirer’s U.S. consolidated income tax return group, the tested income for the CFC’s full year may need to be included in the acquirer’s tax return.

Entities should consider the acquired GILTI obligation related to preacquisition earnings in determining the amount of assets and liabilities to recognize in applying acquisition accounting. Given the complexities that can arise, consultation with appropriate accounting advisers is encouraged.

Example 11-25

Assume the following:

U.S. Parent (USP), a calendar-year entity, acquires U.S. Target (UST), another calendar-year entity, on July 1, 20X2.
USP and UST will file a U.S. consolidated income tax return.
UST owns 100 percent of the stock of CFC (Target CFC), a controlled foreign corporation with a calendar year-end for GAAP and tax purposes.
As of June 30, 20X2, Target CFC is profitable and is expected to have annual tested income that will result in a GILTI inclusion for the year. UST estimated and had accrued a GILTI tax liability of $100 related to Target CFC’s preacquisition earnings.
USP has other profitable CFCs and expects its GILTI tax to increase by $100 because of Target CFC’s preacquisition earnings.

In applying the acquisition method of accounting, USP recognizes, separately from goodwill, the identifiable assets acquired and liabilities assumed of UST and Target CFC. In this case, USP should recognize the $100 of GILTI income tax payable related to Target CFC’s preacquisition earnings as part of the liabilities assumed in connection with the acquisition. Such accounting treatment is appropriate because the tax liability becomes an obligation of USP upon acquisition. Recognition of the liability in the application of acquisition accounting would be appropriate irrespective of the entity’s GILTI accounting policy election (see Section 3.4.10.1 for additional discussion of an entity’s GILTI accounting policy election).

Footnotes

In the calculation of deferred taxes in this example, it is assumed that allocation is consistent with Approach 2 described in Section 11.3.2.2.

The approach an entity selects is an accounting policy election that, like all such elections, should be applied consistently.

Entities should not use this example as a basis for recording an indemnification receivable since they would need additional facts to reach such a conclusion. Rather, entities must evaluate their own facts and circumstances and use significant judgment when determining the appropriateness of such a receivable. Any receivable recorded should be adjusted to reflect collection risk as appropriate.

Rule 5-03 applies to commercial and industrial companies only; however, Regulation S-X, Rules 6-07 and 7-04, provide similar guidance and apply to registered investment companies and insurance companies, respectively.

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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.