11.6 Share-Based Payments

In a business combination, share-based payment awards held by employees of the acquiree are often exchanged for share-based payment awards of the acquirer. ASC 805 refers to the new awards as “replacement awards.” This exchange may or may not be required as part of the acquisition or as part of the acquiree’s stock compensation plan. When the exchange is required as part of the acquisition, the acquirer must analyze the terms of both the preexisting and the replacement awards to determine what portion of the replacement awards is related to past service and therefore part of the consideration transferred in the business combination. The portion of replacement awards that is related to future services should be recognized as compensation cost in the postcombination period. Additional complexities arise when the terms of the replacement awards are different from those of the original awards. See Deloitte’s Roadmap Share-Based Payment Awards for additional discussion about the accounting for equity awards issued in connection with a business combination.

Similarly, ASC 805-740 includes specific income tax accounting guidance related to these types of awards. Because a portion of the fair value of the replacement award may be considered part of the consideration transferred in the business combination, initial and subsequent accounting for the income tax effects of the awards may be complex.

ASC 805-740

Replacement Awards Classified as Equity

25-10 Paragraph 805-30-30-9 identifies the types of awards that are referred to as replacement awards in the Business Combinations Topic. For a replacement award classified as equity that ordinarily would result in postcombination tax deductions under current tax law, an acquirer shall recognize a deferred tax asset for the deductible temporary difference that relates to the portion of the fair-value-based measure attributed to a precombination exchange of goods or services and therefore included in consideration transferred in the business combination.

25-11 For a replacement award classified as equity that ordinarily would not result in tax deductions under current tax law, an acquirer shall recognize no deferred tax asset for the portion of the fair-value-based measure attributed to precombination vesting and thus included in consideration transferred in the business combination. A future event, such as an employee’s disqualifying disposition of shares under a tax law, may give rise to a tax deduction for instruments that ordinarily do not result in a tax deduction. The tax effects of such an event shall be recognized only when it occurs.

Tax Deductions for Replacement Awards

45-5 Paragraph 805-30-30-9 identifies the types of awards that are referred to as replacement awards in this Topic. After the acquisition date, the deduction reported on a tax return for a replacement award classified as equity may be different from the fair-value-based measure of the award. The tax effect of that difference shall be recognized as income tax expense or benefit in the income statement of the acquirer.

11.6.1 Tax Benefits of Tax-Deductible Share-Based Payment Awards Exchanged in a Business Combination

The appropriate income tax accounting for tax-deductible share-based payment awards exchanged in a business combination depends on the timing of the exchange relative to the acquisition date.

11.6.1.1 Income Tax Accounting as of the Acquisition Date

For share-based payment awards that (1) are exchanged in a business combination and (2) ordinarily result in a tax deduction under current tax law (e.g., NQSOs), an acquirer should record a DTA as of the acquisition date for the tax benefit of the fair-value-based measure6 of the acquirer’s replacement award included in the consideration transferred, generally with a corresponding reduction of goodwill. For guidance on calculating the amount of the fair-value-based measure to include in the consideration transferred, see Section 10.2 of Deloitte’s Roadmap Share-Based Payment Awards.

11.6.1.2 Income Tax Accounting After the Acquisition Date

For the portion of the fair-value-based measure of the acquirer’s replacement award that is attributed to postcombination service and therefore included in postcombination compensation cost, a DTA is recorded over the remaining service period (i.e., as the postcombination compensation cost is recorded) for the tax benefit of the postcombination compensation cost.

In accordance with ASC 718, the DTA for awards classified as equity is not subsequently adjusted to reflect changes in the entity’s share price. In contrast, for awards classified as a liability, the DTA is remeasured, along with the compensation cost, in every reporting period until settlement.

11.6.1.3 Income Tax Accounting Upon Exercise of the Share-Based Payment Awards

ASC 805-740-45-5 states, in part, that “the deduction reported on a tax return for a replacement award classified as equity may be different from the fair-value-based measure of the award. The tax effect of that difference shall be recognized as income tax expense or benefit in the income statement of the acquirer.”

The examples below, adapted from ASC 805-30-55, illustrate the income tax accounting for tax benefits received from tax-deductible share-based payment awards that are exchanged in a business combination after the effective date of FASB Statement 141(R).

Example 11-27

The par value of the common stock issued and cash received for the option’s exercise price are not considered in this example.

Assume the following:

Company A has a calendar year-end and therefore adopted FASB Statement 141(R) on January 1, 20X1.
The acquisition date of the business combination is June 30, 20X1.
Company A was obligated to issue the replacement awards under the terms of the acquisition agreement.
The replacement awards in this example are awards that would typically result in a tax deduction (e.g., NQSOs).
Company A’s applicable tax rate is 25 percent.

Company A issues replacement awards of $110 (fair-value-based measure) on the acquisition date in exchange for Company B’s awards of $100 (fair-value-based measure) on the acquisition date. The exercise price of the replacement awards issued by A is $15. No postcombination services are required for the replacement awards, and B’s employees had rendered all of the required service for the acquiree awards as of the acquisition date.

The amount attributable to precombination service is the fair-value-based measure of B’s awards ($100) on the acquisition date; that amount is included in the consideration transferred in the business combination. The amount attributable to postcombination service is $10, which is the difference between the total value of the replacement awards ($110) and the portion attributable to precombination service ($100). Because no postcombination service is required for the replacement awards, A immediately recognizes $10 as compensation cost in its postcombination financial statements. See the following journal entries.

Journal Entry: June 30, 20X1

Journal Entry: June 30, 20X1

On September 30, 20X1, all replacement awards issued by A are exercised when the market price of A’s shares is $150. Given the exercise of the replacement awards, A will realize a tax deduction of $135 ($150 market price of A’s shares less the $15 exercise price). The tax benefit of the tax deduction is $33.75 ($135 × 25% tax rate). Therefore, an excess tax benefit of $6.25 (tax benefit of the tax deduction of $33.75 less the previously recorded DTA of $27.50) is recorded to current income tax expense. See the following journal entry.

Journal Entry: September 30, 20X1

Example 11-28

The par value of the common stock issued and cash received for the option’s exercise price are not considered in this example.

Assume the following:

Company A has a calendar year-end and therefore adopted FASB Statement 141(R) on January 1, 20X1.
The acquisition date of the business combination is June 30, 20X1.
Company A was obligated to issue the replacement awards under the terms of the acquisition agreement.
The replacement awards in this example are awards that would typically result in a tax deduction (e.g., NQSOs).
Company A’s applicable tax rate is 25 percent.

Company A exchanges replacement awards that require one year of postcombination service for share-based payment awards of Company B for which employees had completed the requisite service period before the business combination. The fair-value-based measure of both awards is $100 on the acquisition date. The exercise price of the replacement awards is $15. When originally granted, B’s awards had a requisite service period of four years. As of the acquisition date, B’s employees holding unexercised awards had rendered a total of seven years of service since the grant date. Even though B’s employees had already rendered the requisite service for the original awards, A attributes a portion of the replacement award to postcombination compensation cost in accordance with ASC 805-30-30-12 because the replacement awards require one year of postcombination service. The total service period is five years — the requisite service period for the original acquiree award completed before the acquisition date (four years) plus the requisite service period for the replacement award (one year).

The portion attributable to precombination service equals the fair-value-based measure of the acquiree award ($100) multiplied by the ratio of the precombination service period (four years) to the total service period (five years). Thus, $80 ($100 × [4 years/5 years]) is attributed to the precombination service period and therefore is included in the consideration transferred in the business combination. The remaining $20 is attributed to the postcombination service period and therefore is recognized as compensation cost in A’s postcombination financial statements, in accordance with ASC 718. See the following journal entries.

Journal Entries: June 30, 20X1

Journal Entries: December 31, 20X1

On June 30, 20X2, all replacement awards issued by A vest and are exercised when the market price of A’s shares is $150. Given the exercise of the replacement awards, A will realize a tax deduction of $135 ($150 market price of A’s shares less the $15 exercise price). The tax benefit of the tax deduction is $33.75 ($135 × 25% tax rate). Therefore, an excess tax benefit of $8.75 (tax benefit of the tax deduction of $33.75 less the previously recorded DTA of $25 [$20 + $2.5 + $2.5]) is recorded to current income tax expense. See the following journal entries.

Journal Entries: June 30, 20X2

11.6.2 Settlement of Share-Based Payment Awards Held by the Acquiree’s Employees

As described above, in a business combination, the acquiring company often issues replacement share-based payment awards to the acquiree’s employees. In other situations, however, the acquiring company may choose to cash-settle the awards instead. If the awards are unvested at the time of the business combination, the acquiring company’s discretionary decision to cash-settle the awards will typically result in its recognition of an accounting cost for the unvested portion in the postacquisition period (see ASC 805-30-55-23 and 55-24). However, since the tax deduction may be included in the acquiree’s final tax return, an entity may have questions about when and how to account for the corresponding tax benefit in the acquirer’s financial statements. Consider the following example:

Example 11-29

On December 1, 20X1, Company A enters into an agreement to acquire Company B, in which A offers to purchase all issued and outstanding shares of B. Under the terms of the purchase agreement, A is required to cash-settle all outstanding employee awards held by B’s employees. Company A agrees to pay each holder of the awards, through B’s payroll system, a cash payment due on settlement no later than five business days after the closing of the purchase agreement. As a result, vesting will be accelerated for all of B’s unvested employee awards that A will cash-settle.

During negotiations of the purchase agreement, A agrees to the cash-settlement provision because it wants to (1) compensate B’s employees and (2) establish postacquisition compensation arrangements that would be consistent with A’s existing compensation arrangements. Because no postcombination services are required by holders of B’s awards that will be cash-settled, and because the decision to accelerate the awards is made at A’s discretion, the accelerated unrecognized compensation cost of B’s awards will be accounted for as if A had decided to accelerate the vesting of B’s awards immediately after the purchase-agreement closing. Therefore, A will allocate the fair value of these awards to postcombination compensation cost because all the awards that were outstanding and cash-settled were unvested before the close of the acquisition.

Company B will file a short-period income tax return for the period of January 1, 20X1, through December 1, 20X1, because it was purchased by A. Under the agreement, on December 6, 20X1, B cash-settles all awards outstanding. The settlement of B’s awards is tax deductible in B’s short-period tax return for the period ended December 1, 20X1, because B cash-settles the awards within two-and-a-half months of the end of B’s taxable period ending December 1, 20X1. The income tax deduction for the cash-settled awards reduces taxable income and creates an NOL carryforward in B’s income tax return for the short period ended December 1, 20X1. This NOL carryforward is available to reduce A’s postcombination taxable income.

Because the cash settlement of B’s awards is deductible for tax purposes in B’s precombination consolidated tax return and payment does not occur until December 6, 20X1, A’s tax-basis acquisition accounting balance sheet will reflect not only the NOL but also an employee compensation liability as of the close of the acquisition on December 1, 20X1. Company A is accounting for the compensation cost associated with the cash-settled awards attributable to postcombination services as a transaction that is separate from the business combination. As a result, A will have postcombination compensation cost for which the related tax deduction will be claimed on B’s precombination tax return.

Each of the following alternatives is acceptable in accounting for the tax consequences (deduction claimed by B) of the postcombination compensation expense that is recognized separately and apart from the business combination:

Alternative 1 — Recognize all tax consequences in purchase accounting — Recognizing the tax consequences of the postcombination compensation cost in purchase accounting is consistent with B’s deduction of the compensation cost on its income tax return for the precombination short period. Company A’s acquisition tax-basis balance sheet reflects the tax consequences related to the deduction claimed by B. As a result, the acquisition balance sheet includes a DTA related to the NOL carryforward created by the deduction claimed on B’s tax return. In addition, the acquisition balance sheet will also include a DTL representing the taxable temporary difference related to A’s assumed obligation to settle B’s awards, which is included in A’s tax return but is not recognized for book purposes until after the combination.
Alternative 2 — Recognize tax consequences separately from purchase accounting — Under this alternative, because ASC 805 requires entities to recognize the compensation cost in the postcombination financial statements, it is assumed that the tax effects of the postcombination compensation cost also arise separately from the business combination in A’s postcombination financial statements. Accordingly, there is no DTA or DTL established in B’s acquisition balance sheet. Rather, it is assumed that A receives a tax deduction that creates a DTA (to the extent that such deduction increased an NOL carryforward) or reduction in taxes payable (to the extent that such deduction reduced taxes payable) separately from the business combination, which results in a tax benefit for A in the postcombination financial statements.

Although the balance sheet presentation of each alternative would differ, the same amount of goodwill and tax effects would be reflected in the postcombination income statement.

11.6.3 Tax Effects of Replacement Awards Issued in a Business Combination That Would Not Ordinarily Result in Tax Deductions

Under ASC 805-740-25-11, an acquirer should not record a DTA as of the acquisition date for the tax benefits of the fair-value-based measure of its replacement share-based payment awards included in the consideration transferred that do not ordinarily result in a tax deduction (e.g., ISOs).

11.6.4 Tax Effects of a Disqualifying Disposition in a Business Combination

Because of events that occur after the acquisition date (e.g., a disqualifying disposition), the acquirer may receive a tax deduction associated with replacement awards that would not ordinarily result in tax deductions. The tax effects of such events are recognized only when they occur and would be recorded in the income tax provision.

Footnotes

This guidance uses the term “fair-value-based measure”; however, ASC 718 also permits the use of “calculated value” or “intrinsic value” in specified circumstances. This guidance would also apply in situations in which calculated value or intrinsic value is permitted.

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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.