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The acquirer should identify and measure the deductible and taxable temporary differences of the acquired business and record the resulting deferred tax assets and liabilities.

10.4.1 Acquired temporary differences and tax benefits

In accordance with ASC 805-740-25-3, recognition of deferred tax assets and liabilities is required for substantially all temporary differences and acquired tax carryforwards and credits. Exceptions include temporary differences for nondeductible goodwill (see TX 10.8.3), and, in certain circumstances, the acquired basis difference between the parent’s carrying amount of the subsidiary’s net assets (or investment) in the financial statements and its basis in the shares of the subsidiary (also referred to as the outside basis difference) (see TX 11).The exception for nondeductible goodwill does not extend to identifiable intangible assets with an indefinite life. These assets may seem similar to goodwill, but are significantly different in their nature because, unlike goodwill, they do not represent residual values. Therefore, differences between the book bases and tax bases of all acquired identifiable intangible assets are temporary differences for which deferred taxes should be provided.
Example TX 10-1 provides an example for recognizing and measuring deferred taxes on acquired temporary differences.
EXAMPLE TX 10-1
Recording deferred taxes on acquired temporary differences
Company Z acquires Company X in a nontaxable stock acquisition for total consideration of $1,000. The fair value of the acquired identifiable net assets is $800. The carryover historical tax bases of the acquired net identifiable assets is $500. The tax rate is 25%.
What deferred taxes should be recorded by Company Z in acquisition accounting?
Analysis
Company Z should record the following journal entries in acquisition accounting:
Dr. Net asset
$800
Dr. Goodwill
$275 1
Cr. Cash
$1,000
Cr. Net deferred tax liability
$75 2
1 Goodwill is calculated as the residual after recording the identifiable net assets acquired and associated deferred tax assets and liabilities ($1,000 – ($800 – $75)).
2 The net deferred tax liability is calculated as the difference between the book bases (in this case, the fair value) of the identifiable net assets acquired and the carryover tax bases at the applicable tax rate (($800 – $500) × 25%).

10.4.2 Expected manner of recovery or settlement

The carrying amount of an asset will generally be recovered through use, sale, or both. The tax consequences of using an asset or settling a liability are sometimes different from selling net assets and may directly affect the tax that would be payable in the future. There may be different tax rates for ordinary income and capital gain income. Assets may sometimes be revalued or indexed to inflation for tax purposes only if the asset is sold (i.e., the tax basis is increased for the purpose of determining capital gain income but not ordinary income). Moreover, the ability to file consolidated, combined, or unitary tax returns, and elections or post-acquisition transactions may affect the tax that would be payable from the recovery of an asset. In some jurisdictions, recovery of assets through use will have no tax consequences, while recovery through sale will have tax consequences. The expected manner of recovery needs to be considered to determine the future tax consequences and corresponding deferred taxes in acquisition accounting.
ASC 740-10-25-20 notes that, inherent in an entity’s statement of financial position is the assumption that the reported amounts of assets will be recovered and the reported amounts of liabilities will be settled. Consequently, in the case of financial statement assets that do not have a corresponding tax basis (e.g., intangible assets established in a nontaxable business combination), there is the presumption that, if the asset were to be recovered at its book carrying value, the gain on the sale proceeds would represent a future tax effect that must be accounted for.
Refer to TX 3.3.3 for further discussion of the impact of indexing for tax purposes on the calculation of deferred taxes and TX 8.6.2 on the accounting for a change in tax status as part of a business combination.

10.4.3 Identifying the applicable tax rate for deferred taxes

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?
Analysis
Yes. The consolidated financial statements should include deferred taxes related to the book versus tax basis differences of the acquired net assets. The deferred taxes should be measured at the enacted income tax rate applicable to the acquired business. The tax rate applied should consider the jurisdiction in which the acquired assets will be recovered and the assumed liabilities settled, even if the parent’s basis in the investment has not been pushed down to the separate financial statements of the acquired business.

10.4.4 Deferred taxes related to outside basis differences

A business combination may include the acquisition of certain temporary differences for which ASC 740-10-25-3 provides an exception for recording deferred taxes. For example, when the tax basis in the shares of certain entities differs from the financial reporting basis (i.e., there is an outside basis difference), no deferred tax liability is required for the outside basis difference if the parent can establish the intent and ability to indefinitely delay reversal of the difference. This exception applies to foreign subsidiaries and foreign corporate joint ventures (that are essentially permanent in duration). For domestic subsidiaries, according to ASC 740-30-25-7, if the parent has the intent and can demonstrate an ability to eliminate the outside basis difference in a tax-free manner, then no deferred tax liability is required to be recorded.
A company meets the indefinite reversal criteria if it can assert the intent and ability to indefinitely reinvest earnings abroad and not repatriate the earnings. The determination of whether deferred taxes related to the outside basis differences should be recorded at the acquisition date is based on the acquirer’s intent regarding the acquired investments. For example, if the acquirer intends to repatriate earnings from the acquired entity and cause a reversal of the outside basis difference, then a deferred tax liability should be recognized in acquisition accounting because the liability existed at the acquisition date and was assumed by the acquirer. This is true even if the acquiree had previously not recorded deferred taxes on its outside basis differences.
The impact of the acquirer’s intent related to assets already owned by the acquirer should be evaluated separately from the acquirer’s intent related to assets acquired. The effect of a change in the assertion related to an acquirer’s intent and ability to indefinitely delay the reversal of temporary differences related to subsidiaries it owned prior to the acquisition is recorded outside of acquisition accounting.
The outside tax basis of an investment may exceed the book basis. ASC 740-30-25-9 prohibits the recognition of a deferred tax asset for an investment in a subsidiary or corporate joint venture that is essentially permanent in duration unless the temporary difference is expected to reverse in the foreseeable future.

10.4.4.1 Considerations related to unborn foreign tax credits

An acquirer and acquiree may have “unborn” foreign tax credits (FTCs). That is, foreign taxes that have been paid or accrued by the foreign subsidiary but which are not yet eligible as a credit to the parent because the earnings remittance, or other tax triggering event, has not yet occurred. These unborn FTCs do not currently exist as a separate tax asset, but will be generated upon reversal of an outside basis difference (e.g., remittance of earnings). See TX 11.5.1 for further discussion of unborn FTCs.
The impact of the acquirer’s unborn FTCs should be considered in measuring the deferred tax liability recorded in acquisition accounting on the outside basis in acquiree’s foreign subsidiaries. The result would be different if the acquirer's FTCs have been generated and exist as a separate tax asset. For example, if the acquisition results in the acquirer changing its assessment of the realizability of its deferred tax asset for FTC carryforwards (i.e., for credits that have already been generated), the benefit from releasing a valuation allowance would be recorded outside of acquisition accounting. The distinction is that FTC carryforwards are a separate tax return attribute for which a deferred tax asset is recorded, whereas an unborn FTC is not a separate tax asset and is only considered in measuring other deferred taxes (e.g., an acquiree’s outside basis difference). See TX 10.5.4 for further discussion of changes in the acquirer’s deferred tax balances related to acquisition accounting.
Similarly, the impact of the acquiree’s unborn FTCs should be considered in measuring the acquirer’s deferred tax liability on its existing outside basis differences. If the acquiree’s unborn FTCs change the measurement of the acquirer’s existing deferred tax liability, the reduction in the acquirer’s deferred tax liability is recorded outside of acquisition accounting.
An acquiree may have a deferred tax asset for FTC carryforwards (i.e., for credits that have already been generated). The deferred tax asset would be recorded in acquisition accounting. In this situation, even though the FTC carryforwards may reduce the amount of tax paid when the acquirer’s taxable temporary difference reverses, the FTC carryforward is a separate tax asset acquired in the business combination, and therefore, should be reflected in acquisition accounting. This is true even if the acquiree previously had a valuation allowance against the FTC carryforward deferred tax asset but the acquirer determines a valuation allowance is not required.
An acquisition of a business may also affect the amount of the acquirer’s Global Intangible Low-Taxed Income (GILTI) tax in the year of acquisition and the related GILTI FTCs that can be utilized against GILTI income. Question TX 10-1 addresses whether an asset should be recorded for these GILTI FTCs in acquisition accounting.
Question TX 10-1
Company X accounts for GILTI as a period cost. In Q2 of the current year, Company X purchased Company Y and plans to include Company Y in its US consolidated tax return. Company Y historically generates more GILTI FTCs than it can use. However, as a result of the acquisition, Company X expects that the GILTI FTCs that will arise in the current year from Company Y’s operations prior to the acquisition date will be able to offset GILTI taxes of the Company X consolidated group (including Company Y) in the year of acquisition. Should Company X reflect the benefit of these Company Y GILTI FTCs as part of acquisition accounting?
PwC response

Yes, we believe it is appropriate for Company X to reflect the benefit of these GILTI FTCs in acquisition accounting. The GILTI FTCs that will arise in the current year from Company Y’s operations prior to the acquisition date are based on the foreign income earned and the taxes paid (accrued) through that date. Therefore, if Company X will be able to use those GILTI FTCs to reduce its GILTI tax, the GILTI FTCs should be recognized as a reduction to taxes payable (or an increase to taxes receivable) at the acquisition date.

10.4.5 Deferred taxes—assumed liabilities and contingencies.

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.
1. Consider the impact of the future settlement or resolution on tax-deductible goodwill in the initial comparison to book goodwill as if the assumed liability, contingency, or contingent consideration was settled at its book basis at the acquisition date.
2. Treat the assumed liability, contingency, or contingent consideration as a separately deductible item. A deferred tax asset would be recorded in acquisition accounting because the liability, when settled, will result in a future tax deduction. That is, a deferred tax asset is recognized at the acquisition date since there is a basis difference between book and tax related to the liability. The deferred tax asset would be calculated by multiplying the temporary difference by the applicable tax rate. Under this approach, the initial comparison of book goodwill to tax-deductible goodwill for this particular component simply reflects the book goodwill and tax-deductible goodwill that exists at the acquisition date (i.e., the contingency is included in book goodwill but not in tax-deductible goodwill) even though the liability will be added to tax-deductible goodwill when settled.
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
Deferred tax considerations
Topic
Financial reporting
Taxable transaction
Nontaxable transaction
Assumed liabilities
Acquisition date:
Record at fair value 1 as determined by applying ASC 805, Business combinations.
If settlement would result in tax-deductible goodwill, then the recorded amount of the liability is added to the tax basis goodwill balance. A deferred tax asset would be recorded for any excess tax-deductible goodwill (as adjusted) over book goodwill.
If settlement would result in a tax-deductible asset (other than goodwill), then the recorded amount of the liability is added to the tax basis of such asset. Record deferred taxes on the resulting book versus tax basis difference if required under ASC 740.
If settlement would result in a tax deduction or tax-deductible asset (other than goodwill), then a deferred tax asset should be recorded.
Subsequent adjustment:
Adjust the liability periodically, as required under relevant accounting guidance (various).
If settlement would result in tax-deductible goodwill, then record deferred taxes on the amount of the adjustment. Do not reperform the acquisition date comparison of tax-deductible goodwill to book goodwill.
If settlement would result in a tax-deductible asset (other than goodwill), then the amount of the adjustment is added to the tax basis of the asset.
In both instances, any deferred tax effect is reflected in income tax expense in the income statement.
If settlement would result in a tax-deductible asset (other than goodwill), then a deferred tax asset should be recorded.
Settlement:
Reverse the liability through payment or other settlement.
Apply the same treatment as for “subsequent adjustment” if settled at an amount different than previously recorded.
Apply the same treatment as for “subsequent adjustment” if settled at an amount different than previously recorded.
Contingencies
Acquisition date:
Record at fair value if determinable 1or if not, at an amount determined by applying ASC 450, Contingencies.
If settlement would result in tax-deductible goodwill, then the recorded amount of the contingency is added to the tax basis goodwill balance. A deferred tax asset would be recorded for any excess tax-deductible goodwill (as adjusted) over book goodwill.
If settlement would result in a tax-deductible asset (other than goodwill), then the recorded amount of the contingency is added to the tax basis of such asset. Record deferred taxes on the resulting book versus tax basis difference if required under ASC 740.
If settlement would result in a tax deduction or tax-deductible asset (other than goodwill), then a deferred tax asset should be recorded.
Subsequent adjustment:
Adjust the contingency periodically, as required.
If settlement would result in tax-deductible goodwill, then record deferred taxes on the amount of the adjustment. Do not reperform the acquisition date comparison of tax-deductible goodwill to book goodwill.
If settlement would result in a tax-deductible asset (other than goodwill), then the adjustment is added to the tax basis of the asset.
In both instances, any deferred tax effect is reflected as part of income tax expense in the income statement.
If settlement would result in a tax-deductible asset (other than goodwill), then a deferred tax asset should be recorded.
Settlement:
Reverse the contingency through payment or other settlement.
Apply the same treatment as for “subsequent adjustment” if settled at an amount different than previously recorded.
Apply the same treatment as for “subsequent adjustment” if settled at an amount different than previously recorded.
Contingent consideration 2
Acquisition date:
Record at fair value 1as determined by applying ASC 805, Business combinations.
If settlement would result in tax-deductible goodwill, then the recorded amount of the contingency is added to the tax basis goodwill balance. A deferred tax asset would be recorded for any excess tax-deductible goodwill (as adjusted) over book goodwill.
If settlement would result in a tax-deductible asset (other than goodwill), then the recorded amount of the contingency is added to the tax basis of the asset. Record deferred taxes on the resulting book versus tax basis difference if required under ASC 740.
If settlement would result in an increase in the tax basis of the shares (i.e., outside basis), then the recorded amount of the liability would be added to the tax basis of the shares to determine the outside basis temporary difference. Deferred taxes would not be recognized unless deferred taxes are otherwise provided on the outside basis difference.
Subsequent adjustment:
Record at fair value each period except for equity-classified arrangements.
If settlement would result in tax-deductible goodwill, then record deferred taxes on the amount of the adjustment. Do not reperform the acquisition date comparison of tax-deductible goodwill to book goodwill.
If settlement would result in a tax-deductible asset (other than goodwill), then the adjustment is added to the tax basis of the asset.
In both instances, any deferred tax effect is reflected as part of income tax expense in the income statement.
If settlement would result in an increase in the tax basis of the shares (i.e., outside basis), then deferred taxes should not be adjusted unless deferred taxes are already being recorded on the outside basis difference.
Settlement:
Reverse the contingency through payment or other settlement.
Apply the same treatment as for “subsequent adjustment” if settled at an amount different than previously recorded.
Apply the same treatment as for “subsequent adjustment” if settled at an amount different than previously recorded.
1ASC 805-20-25-17 and ASC 805-20-30-12 provide a summary of exceptions to the recognition and fair value measurement principles in ASC 805.
2Contingent consideration generally represents an obligation of the acquirer to transfer additional assets or equity interests to the selling shareholders if certain future events occur or conditions are met.

10.4.5.1 Assumed liabilities/contingencies—taxable transactions

In a taxable business combination, the settlement of an assumed liability, contingency, or contingent consideration will often impact the ultimate amount of tax-deductible goodwill.
Initial recognition including measurement period adjustments
Following the first approach described in TX 10.4.5, the recorded amount of the assumed liability, contingency, or contingent consideration is added to the tax-deductible goodwill balance as if it were settled at the acquisition date. A deferred tax asset should be recorded if the amount of that hypothetical tax-deductible goodwill (as adjusted for the liability or contingency) exceeds the amount of book goodwill. Because the deferred tax asset is related to goodwill, an iterative calculation is required to determine the amount of the deferred tax asset. However, no deferred tax liability is recorded if book goodwill exceeds the hypothetical tax goodwill (ASC 805-740-25-9). See TX 10.8 for further information on recording deferred taxes on goodwill.
Example TX 10-3 illustrates the described approach for determining deferred tax balances related to contingent consideration at the acquisition date in a taxable business combination.
EXAMPLE TX 10-3
Acquisition date deferred taxes related to contingent consideration in a taxable business combination
Assume contingent consideration is valued on the acquisition date in a taxable business combination at $1,000. Goodwill for book purposes (including the recognition of contingent consideration) is $3,000. Tax-deductible goodwill is $1,800, which excludes any amount of contingent consideration not yet paid. The applicable tax rate for all periods is 25%. For tax purposes, when the contingent consideration is settled, it will become part of the tax basis of goodwill.
Should deferred taxes be recorded in acquisition accounting related to the contingent consideration?
Analysis
It depends. To determine deferred taxes at the acquisition date, consider the tax consequence that will result if the contingent consideration is settled at its recorded amount for book purposes. Because the amount of contingent consideration would be added to tax-deductible goodwill when settled, it is added to the existing balance of tax-deductible goodwill to determine whether there is an excess of tax or book goodwill. The goodwill balances are analyzed as follows:
Book goodwill
$ 3,000
Tax-deductible goodwill
$ 1,800
Contingent consideration
 1,000
Tax-deductible goodwill (as adjusted)
  2,800
Excess of book over tax-deductible goodwill
$  200
Because book goodwill exceeds tax-deductible goodwill, no deferred taxes would be recognized. However, if the tax-deductible goodwill (as adjusted) exceeded book goodwill, a deferred tax asset would be recognized. For example, if the contingent consideration was valued at $1,500 at the acquisition date, the tax-deductible goodwill (as adjusted) would have been $3,300. The excess over the book goodwill of $300 would have resulted in a deferred tax asset. See TX 10.8.2.1 for further information on how the deferred tax asset is calculated.
The same approach applies to assumed liabilities and contingencies in a taxable business combination.

Subsequent adjustments other than measurement period adjustment
In general, adjustments in subsequent periods to assumed liabilities, contingencies, and contingent consideration are recorded in earnings. The appropriate deferred tax treatment related to these adjustments is determined by considering the expected tax consequences, assuming settlement at book carrying amounts. The related deferred tax asset is adjusted if the adjustment to the assumed liability, contingency, or contingent consideration would cause a tax consequence (e.g., increase or decrease a deductible expense or asset).
The acquisition date comparison of book goodwill to tax-deductible goodwill should not be reperformed subsequent to the acquisition date. For example, a deferred tax asset should be recognized or adjusted along with the related income tax expense or benefit when contingent consideration is increased subsequent to the acquisition date for a change in fair value, and the settlement of the contingent consideration would increase tax-deductible goodwill. This is true even if no deferred tax asset was recorded at the date of acquisition (i.e., tax goodwill did not exceed book goodwill at the acquisition date).
Similarly, a decrease in the contingent consideration liability subsequent to the acquisition date due to a change in fair value causes a decrease in the tax-deductible goodwill. The tax impact of the decrease in the contingent consideration liability will be recorded by either (1) recording a deferred tax liability (i.e., when book goodwill exceeded tax-deductible goodwill at the acquisition date), or (2) reducing a deferred tax asset (i.e., when tax-deductible goodwill exceeded book goodwill at the acquisition date).
Example TX 10-4 illustrates accounting for the deferred tax effects of an adjustment to contingent consideration in a taxable business combination.
EXAMPLE TX 10-4
Deferred tax effects of an adjustment to contingent consideration in a taxable business combination
Assume contingent consideration in a taxable business combination is valued on the date of acquisition at $1,000. At the acquisition date, goodwill for book purposes (including the initial recognition of contingent consideration) is $3,000. Tax-deductible goodwill is $1,800 (not considering contingent consideration). Once the contingent consideration is settled, it will be included in tax-deductible goodwill. At the acquisition date, book goodwill of $3,000 exceeded tax-deductible goodwill of $2,800 ($1,800 plus the assumed settlement of the contingent consideration at book basis of $1,000); therefore, no deferred tax was recorded for contingent consideration.
In year two, the fair value of the contingent consideration increases by $700 to $1,700. In year three, contingent consideration is settled at $1,700. The applicable tax rate for all periods is 25%. For simplicity, the effects of amortization of tax goodwill are excluded from the example.
How are deferred taxes impacted as a result of the contingent consideration adjustment and settlement?
Analysis
When settled, the additional consideration will result in additional tax-deductible goodwill. Therefore, a deferred tax asset related to the increase in fair value in year two would be recorded, even though no deferred tax related to tax-deductible goodwill was recorded at the acquisition date. This is because the acquisition date comparison of book to tax goodwill is not revisited.
The following entry would be recorded:
Dr. Expense
$700
Dr. Deferred tax asset
$175 1
Cr. Contingent consideration liability
$700
Cr. Deferred tax expense
$175
1$700 x 25%
The same treatment would apply if there were a decrease in the contingent consideration. For example, if the contingent consideration had decreased by $700, a deferred tax liability of $175 would have been recorded.
Because the contingent consideration is settled for the amount previously recorded, there is no further impact on earnings or deferred taxes in year three. The deferred tax asset is not adjusted because the contingent consideration was settled at the recorded amount for book purposes, but it has not yet been deducted for tax purposes (i.e., the deduction will occur over time as goodwill is amortized).
The same treatment would apply for an assumed or contingent liability in a taxable business combination.

Equity-classified contingent consideration
For financial reporting purposes, a contingent consideration arrangement that is equity-classified is not remeasured after the acquisition date for any subsequent changes in fair value. However, in most cases, for tax purposes, the contingent consideration will be ultimately measured (and create tax basis) at the fair value on the date of settlement. When settled and additional tax basis arises, it may be appropriate to recognize a deferred tax consequence at that point. We believe the appropriate accounting for any deferred tax consequences from an equity-classified contingent consideration arrangement is to reflect the deferred tax affects as an increase in contributed capital pursuant to ASC 740-20-45-11(g).
Example TX 10-5 illustrates the income tax accounting implications of equity-classified contingent consideration.
EXAMPLE TX 10-5
Accounting for tax effects from the settlement of equity-classified contingent consideration
Assume an equity-classified contingent consideration arrangement is valued and measured on the date of acquisition in a taxable business combination at $100,000. The contingent consideration will be settled by issuing stock to the seller when certain performance conditions are met, at which time the fair value of the equity consideration issued will be included in tax-deductible goodwill. At acquisition, book goodwill exceeds tax goodwill by $100,000, and, therefore, no deferred tax is recorded for the equity-classified contingent consideration. The fair value of the contingent consideration increases by $50,000 to $150,000 in year two when the shares are issued to the seller. The applicable tax rate is 25%.
How should the tax effects from the settlement of the equity-classified contingent consideration be recorded?
Analysis
There would be a reclassification within equity (of the original acquisition date fair value) to reflect actual issuance of the securities. The settlement would have no other pre-tax consequence to the assets, liabilities, income, or equity of the company. However, the settlement results in additional tax basis in goodwill of $50,000, which will be amortized along with the initial $100,000 basis in future periods. The tax benefit from the additional tax basis, net of any valuation allowance, should be recognized in equity.
The following entry would be recorded:
Dr. APIC-contingent consideration
$100,000
Dr. Deferred tax asset
$12,500 1
Cr. Common stock
$100,000
Cr. APIC
$12,500
1$50,000 x 25%

10.4.5.2 Assumed liabilities/contingencies—nontaxable transactions

Because no tax-deductible goodwill is created in a nontaxable transaction, the tax implications of the settlement of an assumed liability, contingency, or contingent consideration differs from that in a taxable transaction.
Assumed liabilities or contingent liabilities
The amount paid to settle an assumed or contingent liability recorded in a nontaxable business combination may result in a tax deduction. A deferred tax asset should be recorded in acquisition accounting for the assumed liability or contingency if the applicable tax laws would allow for a deduction when the assumed or contingent liability is settled. This concept is illustrated in Example TX 10-6.
EXAMPLE TX 10-6
Deferred tax impact of contingent liabilities in a nontaxable business combination
Assume a contingent liability is recorded at fair value of $1,000 on the date of acquisition in a nontaxable business combination. The tax basis in the contingent liability is zero. When the liability is settled, the company will receive a tax deduction for the amount paid. The tax rate is 25%.
Should deferred taxes be recorded in acquisition accounting related to the contingent liability?
Analysis
Yes. The contingent liability is a temporary difference at the acquisition date because it has zero tax basis and will result in a tax deduction when settled. The following entry would be recorded at the acquisition date:
Dr. Deferred tax asset
$250
Dr. Goodwill
$750
Cr. Contingent liability
$1,000
The deferred tax asset should be adjusted in subsequent periods as the amount of the contingent liability changes. Both adjustments would be recorded in the income statement.

Contingent consideration
The settlement of contingent consideration in a nontaxable business combination often will be added to the outside tax basis as part of the amount paid for the acquiree. Therefore, the contingent consideration would be added to the outside tax basis for purposes of determining the difference between outside tax basis and book basis. However, deferred taxes would not be affected by the contingent consideration at the acquisition date or upon adjustment to the amount of contingent consideration in subsequent periods unless a company is providing deferred taxes on outside basis differences. When deferred taxes are not affected, any subsequent changes in the fair value of the contingent consideration could impact an entity’s effective tax rate because the pre-tax effect would be recorded in the income statement without a corresponding tax effect. See TX 10.4.4 for further information on recording deferred taxes on outside basis differences.

10.4.6 Deferred taxes for research and development activities

Research and development activities (R&D) acquired in a business combination will be capitalized as tangible or intangible assets based on their nature. The capitalized in-process R&D (IPR&D) activities are accounted for as indefinite-lived intangible assets, subject to impairment testing until completion or abandonment of the projects. The acquirer estimates the useful life of the asset once each project is complete (ASC 805-20-35-5).
Deferred 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?
Analysis
It depends. Company A must estimate both when the R&D project will be completed and the expected useful life of the resulting intellectual property intangible asset in order to determine whether the deferred tax liability related to the R&D intangible asset can be used as a source of taxable income. If Company A expects the project to be completed within two years and expects the useful life of the intangible asset to be three years, then the deferred tax liability should be used as a source of income in assessing the realization of the deferred tax asset because the deferred tax liability is expected to reverse (over years three to five) before the NOL carryforward expires. Any benefit recognized if Company A reverses all or a portion of its valuation allowance would be recorded outside of acquisition accounting in continuing operations.

10.4.7 Deferred taxes related to acquisition-related costs

Under ASC 805, acquisition-related costs are not part of the fair value of the consideration that is transferred. 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?
Analysis
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.
Although the transaction costs in this example appear to be similar to the organizational costs described in ASC 740-10-25-25, for which deferred taxes would be recognized, we believe an important distinction exists. The organization costs contemplated in ASC 740-10-25-25 are deductible for tax purposes over a specified period. The transaction costs in this example are not deductible except through specified transactions that are tantamount to a sale or complete impairment of Target. Thus, even though the transaction costs technically are not part of the tax basis in the stock of Target, we believe they are analogous to an excess of outside tax basis over book basis. Accordingly, we believe it is appropriate to analogize to the guidance in ASC 740-30-25-9, which prohibits the recognition of a deferred tax asset for an excess of the tax basis over the book basis of a subsidiary unless it is apparent that the temporary difference will reverse in the foreseeable future.

10.4.8 Deferred taxes—exception on foreign exchange matters

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 at historical exchange rates does not apply at the acquisition date. Therefore, the difference between the fair value of acquired assets and liabilities measured in the functional currency at the acquisition date and the tax basis is a temporary difference for which a deferred tax asset or liability 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.

10.4.9 Changes in measurement of the acquired deferred taxes

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?
Analysis
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.
Dr. Goodwill
$225
Dr. Deferred tax liability
75
Cr. Property, plant & equipment
$298
Cr. Depreciation expense
2
To recognize the reduction in the fair value of the building and the cumulative adjustment to depreciation expense (assumes one quarter previously taken based on provisional value and a 40-year life for the building), the corresponding deferred tax effects at the acquisition date, and the offsetting adjustment to goodwill.
Dr. Deferred tax expense
$75
Cr. Deferred tax asset valuation allowance
$75
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.

10.4.10 Effects of post-acquisition elections

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.
  • Whether the election or transaction is available and contemplated as of the acquisition date, or within the measurement period based on information and facts that existed at the acquisition date (even if the final decision to implement it occurs after the acquisition date). Actions that are based on information that was not known or knowable, or circumstances that did not exist as of the acquisition date, are based upon new information and their effects should be accounted for outside of acquisition accounting.
  • Whether the election or transaction is primarily within the acquirer’s control with no significant complexities or uncertainties as to whether the transaction will actually be completed. If implementation is contingent on obtaining third-party approval (including a tax ruling) or meeting legal or regulatory requirements, it generally is not primarily within the acquirer’s control.
  • Whether the acquirer is required to make a payment (separate from consideration exchanged for the business) or forgo tax attributes to obtain the tax benefits; in this regard, the mere realization or settlement of an acquired deferred tax liability is not considered a separate payment. If a separate payment (or sacrifice of tax attributes) is required to obtain tax benefits, the effects would generally be recorded outside of acquisition accounting.
  • Whether other significant costs will be incurred to implement the transaction. If significant costs other than payment to a taxing authority must be incurred to implement the transaction, it may indicate that, consistent with the expensing of such costs, the tax effects should also be expensed.
Example TX 10-10 illustrates the accounting for the tax effects of a post-acquisition restructuring.
EXAMPLE TX 10-10
Deferred tax accounting when a planned post-acquisition restructuring will impact the ability to benefit from acquired net operating losses
Company X acquires 100% of the stock of Company Y in a nontaxable transaction. Company Y has state NOLs at the acquisition date in the single state in which it operates. The change in control of Company Y does not impact the utilization of the NOLs under state law. Company X has no presence in that state, which is a non-unitary separate filing state. There is sufficient evidence as of the acquisition date that the NOLs can be realized in the future based on the operations of Company Y; however, Company X has a definitive plan to move Company Y’s headquarters and operations to another state shortly after the acquisition. Because of this planned post-acquisition restructuring action, Company X does not expect the NOLs related to Company Y’s previous state of domicile to be realized.
Should the change in valuation allowance resulting from the restructuring be recorded in acquisition accounting?
Analysis
In these specific facts, we believe there are two alternative views:
View A—Record a DTA for the full amount of acquired state NOLs as part of acquisition accounting and record a valuation allowance and related deferred tax expense in continuing operations for the portion of the NOLs not expected to provide a future tax benefit immediately after the acquisition. Under this view, the buyer is precluded from considering the effects of restructuring actions it expects to take after the acquisition by analogy to the guidance in ASC 805-20-25-2, which requires that restructuring costs the buyer expects but is not obligated to incur to be recorded outside of acquisition accounting.
View B—Record a DTA and a valuation allowance for the portion of the NOLs not expected to provide a future tax benefit as part of acquisition accounting. Under this view, Company X’s expected manner of recovery should be considered in assessing recoverability of acquired DTAs. In that regard, all available evidence should be considered, including planned actions that are primarily within Company X’s control and would affect its ability to realize a benefit from acquired state NOLs.
While both views are acceptable positions based on the facts presented, there may be situations when only one view would be supportable. For example, View A may be the only supportable answer if Company X did not have any intention of relocating Company Y at the acquisition date but decided to do so as a result of having been subsequently offered significant government economic incentives.
In some circumstances, these two views may also be applicable in choosing the jurisdictional tax rate to be applied to acquired temporary differences when a post-acquisition relocation is anticipated. For example, if the acquirer plans to relocate an acquiree’s operation from State A to State B, the view chosen would determine how to account for the effect of the difference in the states’ tax rates on acquired temporary differences.
In situations when either view is supportable, appropriate financial statement disclosures should be provided.

10.4.11 Post-acquisition step-up in tax basis of goodwill (after adoption of ASU 2019-12)

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.

ASC 740-10-25-54

An entity shall determine whether a step up in the tax basis of goodwill relates to the business combination in which the book goodwill was originally recognized or whether it relates to a separate transaction. In situations in which the tax basis step up relates to the business combination in which the book goodwill was originally recognized, no deferred tax asset would be recorded for the increase in tax basis except to the extent that the newly deductible goodwill amount exceeds the remaining balance of book goodwill. In situations in which the tax basis step up relates to a separate transaction, a deferred tax asset would be recorded for the entire amount of the newly created tax goodwill in accordance with this Subtopic. Factors that may indicate that the step up in tax basis relates to a separate transaction include, but are not limited to, the following:
  1. A significant lapse in time between the transactions has occurred.
  2. The tax basis in the newly created goodwill is not the direct result of settlement of liabilities recorded in connection with the acquisition.
  3. The step up in tax basis is based on a valuation of the goodwill or the business that was performed as of a date after the business combination.
  4. The transaction resulting in the step up in tax basis requires more than a simple tax election.
  5. The entity incurs a cash tax cost or sacrifices existing tax attributes to achieve the step up in tax basis.
  6. The transaction resulting in the step up in tax basis was not contemplated at the time of the business combination.

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?
Analysis
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.

10.4.11A Post-acquisition step-up in tax basis of goodwill (before adoption of ASU 2019-12)

When a step-up in the tax basis of tax-deductible goodwill is obtained through a transaction that occurs after an acquisition, a deferred tax asset is recorded if the new tax basis exceeds the book basis in the goodwill; however, a deferred tax liability is not recorded if the book basis exceeds the new tax basis. We are aware of another acceptable view under which the newly arising tax goodwill is viewed as a separate unit of account and is not compared to the pre-existing book goodwill. Under that view, a deferred tax asset is recorded through the income tax provision for the full tax basis. The view applied for such a tax basis step-up in goodwill constitutes an accounting policy that should be followed consistently in similar circumstances.
Example TX 10-11A illustrates the accounting for the tax effects of a post-acquisition tax-free merger.
EXAMPLE TX 10-11A
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 X 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 concluded that it will merge the holding company in Country A into Company Y (i.e., a 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?
Analysis
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.

New guidance
In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes. This guidance clarifies when a step-up in the tax basis of goodwill should be considered part of the business combination in which the book goodwill was originally recognized and when it should be considered a separate transaction. ASU 2019-12 is effective for public business entities for annual reporting periods beginning after December 15, 2020, and interim periods within those reporting periods. For all other entities, it is effective for annual periods beginning after December 15, 2021, and interim periods within annual periods beginning after December 15, 2022. Early adoption is permitted in any interim or annual period, with any adjustments reflected as of the beginning of the fiscal year of adoption. If an entity chooses to early adopt, it must adopt all changes as a result of the ASU. The transition provisions vary by amendment. See TX 10.4.11 for applicable guidance after adoption of ASU 2019-12.
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