In determining deferred taxes, the identification of the applicable tax rate for each jurisdiction (and in some cases for each individual type of temporary difference) is important. An acquirer should consider the effects of the business combination when determining the applicable tax rate. As described in ASC 740-10-30-9, this may be important in jurisdictions in which graduated rates were historically significant for the business because the combined business' operations may require the application of a different statutory rate. See TX 10.5.4 for further information on recording the impact of an expected change in the applicable tax rate on the acquirer’s deferred tax balances.

The applicable rate is determined based on enacted tax rates, even if the parties included apparent or expected changes in tax rates in their negotiations. ASC 740-10-45-15 requires that rate changes be reflected in the period when enacted. Further, a change in enacted rates subsequent to the acquisition date may result in an immediate positive or negative impact on the tax provision in the post-combination period.

Companies may elect to apply pushdown accounting, whereby the parent’s basis in the investment is pushed down to the legal entities acquired. Regardless of whether pushdown accounting is applied, the applicable tax rate used to measure deferred taxes should be determined based on the relevant rate in the jurisdictions where the acquired assets will be recovered and the assumed liabilities settled, as discussed in Example TX 10-2.

EXAMPLE TX 10-2
Determining applicable tax rate

A holding company acquires 100% of the shares of another business in a nontaxable transaction. The holding company is incorporated in a jurisdiction that does not impose income taxes, and the acquired business is in a jurisdiction where income is subject to income taxes. The holding company identifies temporary differences between the fair value (as determined under ASC 805) for financial reporting purposes and the tax bases of the individual assets acquired and liabilities assumed.

Should deferred taxes be recorded for temporary differences resulting from the acquisition?

Acquisition accounting under ASC 805 includes the recognition of assumed liabilities, acquired contingent assets under ASC 450, assumed contingent liabilities under ASC 450, and contingent consideration under ASC 805, all of which affect the amount of book goodwill or other assets recorded at the acquisition date. However, these items generally are not recognized for tax purposes until the amounts are fixed and reasonably determinable or, in some jurisdictions, until they are paid. These conditions often are not met until a future financial statement period. As a result, these items would not have tax basis on the acquisition date. In a taxable transaction, the tax basis in the newly created goodwill generally does not include an incremental amount related to these items (there is no tax-deductible goodwill created in a nontaxable transaction). Therefore, the difference in treatment for these items could give rise to temporary differences for which deferred taxes should be recognized at the date of acquisition and adjusted in subsequent periods as the assumed liability, contingency, or contingent consideration is adjusted for financial reporting purposes or ultimately settled or resolved.

According to the principle in ASC 740-10-25-20(b), a temporary difference for which deferred taxes should be recorded generally exists if the resolution of the contingency or settlement of the assumed liability or contingent consideration will result in a future tax consequence (i.e., deduction or income). The tax consequence is affected by whether the business combination was a taxable or nontaxable transaction. The resolution of a contingent liability acquired in a nontaxable transaction may result in a tax deduction, in which case a deferred tax asset should be recorded on the acquisition date. In a taxable transaction, the settlement of an assumed liability may affect the amount of tax-deductible goodwill, in which case whether deferred taxes are recognized depends on whether book or tax-deductible goodwill is greater. See TX 10.8 for further information on deferred taxes related to goodwill.

If the resolution of the contingency or settlement of the assumed liability will impact the amount of tax-deductible goodwill we believe an acquirer may take one of two acceptable approaches to account for the related deferred taxes.

The resolution of the contingency or settlement of the assumed liability in some cases can also impact other acquired assets. The available accounting approaches for the related deferred taxes are similar to those available when the resolution or settlement impacts tax-deductible goodwill.

Figure TX 10-1 summarizes the deferred tax accounting associated with the most common scenarios for assumed liabilities, contingencies, and contingent consideration in a taxable transaction, using the first approach described above (treatment as if settled at book basis on the acquisition date), as well as deferred tax accounting scenarios in a nontaxable transaction. See TX 10.4.5.1 for further information and examples related to taxable transactions and TX 10.4.5.2 for further information related to nontaxable transactions.

Figure TX 10-1
Deferred taxes related to assumed liabilities, contingencies, and contingent consideration

Research and development activities (R&D) acquired in a business combination will be capitalized as tangible or intangible assets based on their nature. The capitalized in-process R&D (IPR&D) activities are accounted for as indefinite-lived intangible assets, subject to impairment testing until completion or abandonment of the projects. The acquirer estimates the useful life of the asset once each project is complete (ASC 805-20-35-5).

Deferred taxes should be recorded for temporary differences related to R&D intangible assets as of the business combination’s acquisition date. If the tax basis of the R&D intangible asset is less than the book basis, as will generally be the case in a nontaxable business combination, a deferred tax liability will be recorded based on the difference.

Deferred tax liabilities related to indefinite-lived assets typically are not used as a source of income to support realization of deferred tax assets in jurisdictions where tax attributes expire (e.g., jurisdictions where net operating loss carryforwards expire) unless the deferred tax liability is expected to reverse prior to the expiration of the tax attribute. See TX 5.5.1 for additional discussion. The acquirer should determine whether the deferred tax liability related to R&D will reverse in a period that would allow for realization of the deferred tax assets.

Example TX 10-7 illustrates the approach for considering whether a deferred tax liability for R&D activities should be considered a source of income for realizing deferred tax assets.

EXAMPLE TX 10-7
Whether a deferred tax liability for R&D activities should be considered a source of income for realizing deferred tax assets

Company A acquires Company B in a nontaxable business combination. Company A recognizes an acquired R&D intangible asset for $100 and records an associated deferred tax liability of $25. Under ASC 805, the R&D intangible asset is classified as indefinite-lived until the project is either abandoned or completed, at which time a useful life will be determined. Company A plans to file a consolidated tax return with Company B. Company A had a pre-existing deferred tax asset of $20 for NOLs that will expire in 10 years (for simplicity, assume this is the Company’s only deferred tax asset). Prior to the acquisition, Company A had a valuation allowance against the deferred tax asset.

Should the deferred tax liability related to an acquired R&D intangible asset be considered a source of income for realizing deferred tax assets?

Under ASC 805, acquisition-related costs are not part of the fair value of the consideration that is transferred. Such costs are expensed as incurred by the acquirer. However, acquisition-related costs may be treated one of several ways for tax purposes depending on the tax jurisdiction and the type of costs. For example, these costs could be expensed as incurred, capitalized as a separate intangible asset, included in the basis of the shares acquired, included in the basis of other assets, or included in tax-deductible goodwill.

Transaction-related costs incurred by the seller are generally expensed as incurred. However, similar to buyers’ costs, these costs may also be capitalized as a separate asset, included in the basis of the shares sold, or included in the basis of assets sold.

If the acquisition costs are not immediately deductible for tax purposes, a potential temporary difference is created. We believe there are two acceptable alternatives for determining the appropriate deferred tax treatment for acquisition costs.

One alternative is to consider whether the acquisition costs would result in a future tax deduction if the business combination was not consummated. If so, then the acquisition costs represent a deductible temporary difference for which a deferred tax asset should be recognized when the costs are expensed for financial reporting. This approach is considered acceptable because the consummation of a business combination is generally not anticipated for accounting purposes. When the acquisition is consummated, companies will need to revisit the appropriate accounting for the temporary difference and consider whether the deferred tax asset should be reversed. Depending on how the acquisition costs are treated for tax purposes (e.g., added to the outside basis of the shares), it may no longer be appropriate to record deferred taxes on such acquisition costs. Reversal of a deferred tax asset would be reflected in the income statement and would affect the effective tax rate in the period the acquisition is consummated.

Another alternative is to consider the expected ultimate tax consequence of the costs. For example, the acquirer may expect the costs to be included in the outside basis of the shares for tax purposes, as is typically the case in a nontaxable business combination. In this case, no deferred tax asset would be established related to the acquisition costs unless the acquirer expects to record deferred taxes on the outside basis temporary difference. Therefore, the acquisition costs would be expensed with no corresponding tax effect, which would affect the effective tax rate in the period the acquisition costs are expensed. Deferred taxes would be provided on the acquisition costs if those costs are expected to be included in a tax-deductible asset (e.g., tax-deductible goodwill). This approach is considered acceptable because it is appropriate to consider the expected tax consequence of the reversal of the temporary difference in the recognition and measurement of deferred taxes (according to ASC 740-10-25-20). This approach requires a continuous evaluation of expectations at each reporting date and recognition of deferred tax adjustments consistent with revised expectations.

Tax-deductible goodwill is compared to book goodwill at the acquisition date to determine whether a deferred tax asset should be recorded. Under either approach described above, acquisition costs incurred by the acquirer are not included in the tax goodwill amount for purposes of the comparison of tax-deductible goodwill to book goodwill, because the acquisition costs are not included in book goodwill. See TX 10.8 for further information on recording deferred taxes on goodwill.

Since these costs will not be reflected in acquisition accounting for financial reporting purposes, associated deferred taxes that are recorded or later reversed will be reflected in the income statement.

The costs to issue debt or equity securities are recognized in accordance with other applicable GAAP (e.g., ASC 805-10-25-23). Costs to issue debt or equity securities are not part of acquisition accounting. As such, any associated tax effect will be reflected in the income statement or directly in equity, but not in acquisition accounting.

See TX 16.7 for a discussion of acquisition costs in calculating an estimated annual effective tax rate.

Example TX 10-8 illustrates an approach by an acquirer for considering deferred taxes on transaction costs incurred by a target company.

EXAMPLE TX 10-8
Accounting for transaction costs incurred by a target company that are capitalized for tax purposes

Target incurred transaction costs in connection with a recent acquisition of its shares by Buyer. Target is required to capitalize these costs as a separate asset for tax purposes in Jurisdiction A. The resulting tax basis in these capitalized costs survives the acquisition; however, such amounts cannot be amortized for tax purposes and cannot be separately sold. Such costs may be deductible at some indefinite future date, which may occur when the assets that constitute the related trade or business are sold or if and when it is determined that the capitalized costs no longer have any future value. Furthermore, these transaction costs will generally not be deductible if Target is liquidated. If liquidated, the related tax basis will carry over to Buyer.

Should Buyer record a deferred tax asset in acquisition accounting for the difference between the book basis (zero) and tax basis of Target’s capitalized transaction costs?

Generally, no. If a specific event must occur in order for Target to claim a tax deduction for the transaction costs and that event will not occur until some indefinite future date, we believe that it would be inappropriate to recognize a deferred tax asset until it is apparent that the temporary difference will reverse in the foreseeable future.

If an entity’s functional currency differs from its local currency, certain of the entity’s assets and liabilities (e.g., nonmonetary assets) will be remeasured in future periods at historical currency rates. The historical rate for assets and liabilities acquired in a business combination is the rate at the date of the combination. The exception in ASC 740-10-25-3(f) that prohibits recognition of deferred taxes for differences that arise from changes in exchange rates or indexing for tax purposes on assets and liabilities that are remeasured from the local currency into the functional currency using historical exchange rates does not apply at the acquisition date. Therefore, the difference between the fair value of acquired assets and liabilities measured in the functional currency at the acquisition date and the tax basis is a temporary difference for which a deferred tax asset or liability would be established on the acquisition date.

The exception in ASC 740-10-25-3(f) does apply to changes in the temporary difference post-acquisition. See TX 2.4.3 for further discussion of the exception on recording deferred taxes on certain foreign exchange amounts.

The acquirer should consider whether changes in the acquired deferred tax balances are due to new information about facts and circumstances that existed at the acquisition date (measurement period adjustments) or are due to events arising in the post-combination period. For example, the impact of a subsequent business combination occurring during the measurement period of a prior acquisition would likely not qualify as a measurement period adjustment. Therefore, if a subsequent business combination triggers the release of a valuation allowance established in a prior acquisition, such release would typically be recorded as a decrease in income tax expense. The guidance in ASC 805 related to measurement period adjustments for acquired deferred tax balances is consistent with the guidance for changes in other acquired assets and liabilities. See BCG 2.9 for further information on measurement period adjustments.

Adjustments to acquired assets and assumed liabilities during the measurement period are reflected in the reporting period in which the adjustment is determined. In general, changes to deferred tax balances that result directly from measurement period adjustments would be recognized at the same time. Example TX 10-9 illustrates this guidance.

EXAMPLE TX 10-9
Measurement period adjustments related to deferred taxes

Company A acquired Company B in a nontaxable business combination in the first quarter of 20X1. One of Company B’s more significant assets was an office building that had no remaining tax basis. Company A recorded the office building at a provisional fair value of $1,000 and recorded a corresponding deferred tax liability of $250 (25% rate) at the acquisition date. Company A had pre-existing deferred tax assets of $600, for which there was a full valuation allowance in prior periods. Solely as a result of the taxable temporary differences recognized in the business combination, Company A released $250 of its valuation allowance and recognized the benefit in the income statement at the acquisition date in accordance with ASC 805-740-30-3.

In the second quarter of 20X1, Company A completed its measurement of the acquisition date fair value of the office building when it received a third-party appraisal report. The appraisal indicated that the fair value of the building at the acquisition date was only $700, resulting in a deferred tax liability of $175 (and not the $250 previously recorded).

How should Company A record the deferred tax consequences of the subsequent change to the acquisition-date fair value of the office building?

Company A would recognize a reduction in the value of the building and a corresponding reduction to depreciation expense recognized since the date of acquisition. Company A would also recognize a reduction in the deferred tax liability associated with the building and an adjustment to the amount of the valuation allowance released as of the acquisition date. The following journal entries would be recorded.

To re-establish the valuation allowance on deferred tax assets due to the reduced taxable temporary difference upon finalization of the valuation of the building.

Business combinations often involve a considerable amount of business, legal, and tax planning. Tax effects can arise from events ranging from tax-specific elections to more complex reorganizations and business integration actions. These events may alter the income taxes expected to be incurred on recovery of acquired temporary differences. When such events relate to actions contemplated by the acquirer at or prior to the acquisition date, careful analysis is required to determine whether the tax effects should be included as part of acquisition accounting or should be accounted for outside of acquisition accounting as a separate transaction.

The fair value accounting guidance in the business combination standard is based upon market-participant assumptions, which exclude the effects of buyer-specific decisions and transactions. However, the standard identifies income taxes as an exception to the fair value recognition and measurement principles. The acquirer should record all deferred tax assets, liabilities, and valuation allowances in accordance with ASC 740.

Neither ASC 805-740 nor ASC 740 directly address whether the tax effects of post-acquisition elections or transactions should be included in acquisition accounting. This determination requires consideration of specific facts and circumstances and the relevant tax laws.

The determination might be straightforward when, for example, the seller and buyer agree to make a tax election to treat a stock purchase as an asset purchase for tax purposes, thus providing a step-up in the inside tax bases of acquired assets. The buyer is thus able to acquire, through the acquisition negotiations, assets with stepped-up tax bases and should account for the tax election effects in acquisition accounting. However, there are circumstances when the determination is not straightforward and may require significant judgment and analysis.

We believe the following factors should generally be considered.

When a step-up in the tax basis of tax-deductible goodwill is obtained after the acquisition date, it should be determined whether the step-up relates to the business combination or a separate transaction.

ASC 740-10-25-54 provides factors that should be considered in making this determination.

Example TX 10-11 illustrates the accounting for the tax effects of a post-acquisition tax-free merger.

EXAMPLE TX 10-11
Accounting for the income tax effects of a post-acquisition tax-free merger

Company X, a US multinational, has acquired, through a wholly-owned acquisition holding company in Country A, the stock of Company Y, a foreign company domiciled in Country A. The acquisition is treated as a nontaxable acquisition in Country A, and Company Y’s tax bases carry over to the holding company.

Pursuant to tax law in Country A, affiliated entities located in Country A can combine legal entities and operations generally without incurring a tax cost. There are often business and tax motivations for such mergers, including streamlined operations, reduced administrative and legal costs, and a tax basis step-up in the acquired assets. These mergers can be executed any time after an acquisition and, from a tax law perspective, are typically considered more-likely-than-not to be sustained, provided the entities have business substance. No formal approval or ruling from the taxing authority is required, and external approvals (e.g., obtaining certain business permits) generally are considered perfunctory.

During the initial due-diligence process, Company X explored the merits of a merger in Country A but had not made a definitive decision at the acquisition date. Subsequently, Company X concludes that it will merge the holding company in Country A into Company Y (i.e., downstream merger). The decision is based on further analysis of information and facts that existed at the acquisition date. The merger transaction results in a tax basis step-up in Company’s Y assets, including acquired tax-deductible goodwill.

Should the income tax effects of the merger be recorded in acquisition accounting?

The factors provided in ASC 740-10-25-54(a) through ASC 740-10-25-54(f) should be considered in order to determine if the tax basis relates to the business combination or a separate transaction. Under this fact pattern, we believe the anticipated deferred income tax benefit from a tax basis step-up should be incorporated into the recognition and measurement of acquired deferred taxes. This is because the merger transaction and its intended favorable tax consequences are available and considered by Company X as of the acquisition date. That is, the merger transaction and its expected tax effects are based on information and facts existing as of the acquisition date. It is also primarily within Company X’s control and ability as there is no substantive approval or review process. Additionally, Company X is not required to make a separate tax payment or incur significant costs separate from the consideration exchanged to acquire Company Y.