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10.5 Valuation allowance assessment at acquisition
Publication date: 31 Mar 2023
us Income taxes guide
An acquirer that will include the acquiree in a consolidated tax return should consider the deferred tax assets and liabilities and future taxable income of the combined business when assessing whether both the acquirer’s and the acquiree’s deferred tax assets are realizable. In some cases, the combined entity may determine that a valuation allowance will not be necessary for the acquired deferred tax assets even though the target company may have previously recorded a valuation allowance in its historical financial statements. For example, deductible differences or carryforwards of the acquiree may be realizable because the acquirer has sufficient taxable temporary differences that will generate future taxable income, or because the acquirer anticipates having sufficient other future taxable income to ensure realization.
New sources of future taxable income from the perspective of the combined business (in the form of additional taxable temporary differences or increased forecasts of future taxable income) means that more deferred tax assets may be realizable for the combined business at the date of acquisition.
Combined tax attributes or income may also provide evidence as to the realizability of the acquirer’s own deferred tax assets at the date of acquisition. However, changes in the assessment of realizability of the acquiring company’s deferred tax assets are not included in acquisition accounting. See TX 10.5.4 for further information on changes in the acquirer’s deferred tax balances related to acquisition accounting.
10.5.1 Future combined results after the business combination
To determine the need for a valuation allowance at the date of acquisition, it is necessary to consider all available evidence. In jurisdictions where a consolidated tax return will be filed (i.e., acquiring and acquired business consolidated), it may be necessary to consider the expected future taxable income of the combined business.
To perform the evaluation, past results, as well as expected future results, should be considered. It may be appropriate to consider certain pro forma adjustments to the historical operating results of the acquired entity to provide an indication of the future earnings capabilities of the acquired entity after acquisition. For example, if a significant amount of debt is created at the acquired entity in conjunction with the acquisition, it would be appropriate to consider the past results of the acquired entity adjusted to reflect the interest expense that will be incurred on the debt. Conversely, if significant overhead or debt is eliminated from the target, it may be appropriate to adjust the historical operating results in order to provide a more accurate depiction of the business’ future performance.
Temporary differences at the date of acquisition will be measured based on the differences between the carryover tax basis (in a nontaxable acquisition) and the fair values assigned in acquisition accounting. If the fair values are higher, the reversals of resulting taxable differences may themselves ensure realization of future tax benefits. Judgment will have to be applied in reviewing the available evidence to arrive at a meaningful outcome.
In all cases, when assessing the realizability of deferred tax assets, the greatest emphasis should be placed on information that is objectively verifiable. For example, anticipated synergies that are expected to result from the business combination may not be objectively verifiable until they can be demonstrated. On the other hand, it may be appropriate to reduce or exclude certain historical operating costs to the extent they relate to identified redundancies such as duplicate accounting systems that will be eliminated post combination.
10.5.2 Acquirer’s taxable differences as a source of realization
The acquirer’s own deferred tax liabilities may provide a source for the realization of deferred tax assets acquired in a business combination and, therefore, may be an important component in assessing the need for a valuation allowance for the deferred tax assets that arise from the acquisition. As a result, the acquirer may need to determine its temporary differences at the date of acquisition, which may be difficult if the acquisition occurs at an interim date. The acquirer’s temporary differences on the date of the acquisition should be determined in each jurisdiction. There may be more than one reasonable approach to determine the acquirer’s temporary differences at the acquisition date. For example, the acquirer might assume it files a short-period tax return as of the acquisition date, following tax laws governing how annual deductions are determined in a short period return. The existing book bases of the assets and liabilities would be compared with the proforma tax bases to determine the temporary differences. Other possible approaches might include the acquirer assuming that its temporary differences arise evenly throughout the year or in the same pattern that pre-tax accounting income is earned. The acquirer should determine the approach most suitable to its facts and circumstances.
10.5.3 Limitation of tax benefits by law
In certain business combination transactions, the acquired business and its tax attributes may be integrated into the consolidated tax returns and positions of the acquirer. However, depending on the specific tax jurisdiction, there may be various limitations on the use of acquired tax benefits. Some examples of these limitations include:
- Utilization of certain attributes, such as NOLs or tax credits, may be limited due to a change in corporate ownership, structure, or a significant change in business operations. These limitations might be expressed as an absolute amount, a formula-based limitation (e.g., annually changing percentage of the acquired tax benefit), or a relationship to taxable income (e.g., 30% of taxable income can be offset by acquired NOLs).
- Use of acquired loss carryforwards may be limited to post-acquisition taxable income of the acquired business.
All restrictions should be considered in assessing whether the deferred tax assets for acquired tax benefits are realizable.
10.5.4 Changes in acquirer’s deferred taxes due to acquisition
The impact on the acquiring company’s deferred tax assets and liabilities caused by an acquisition is recorded in the acquiring company’s financial statements outside of acquisition accounting. Such impact is not a part of the fair value of the assets acquired and liabilities assumed.
For example, in jurisdictions with a graduated tax rate structure, the expected post-combination results of the company may cause a change in the tax rate expected to be applicable when the deferred tax assets and liabilities reverse. The impact on the acquiring company’s deferred tax assets and liabilities is recorded as a change in tax rates and reflected in earnings.
Additionally, the acquirer’s financial statements may have included a valuation allowance before the transaction for its deductible differences or loss carryforwards and other credits. After considering the transaction, the projected combined results, and available taxable temporary differences from the acquired business, the acquirer may be able to release all or part of its valuation allowance. While this adjustment is a result of the acquisition, ASC 805-740-30-3 requires that the benefits be recognized in income or equity, as applicable, and not as a component of acquisition accounting. This benefit is related to the acquirer’s existing assets and should not be considered in the determination of the fair values of the assets acquired and liabilities assumed.
The tax law in some tax jurisdictions may permit the future use of either of the combining entities’ deductible temporary differences or carryforwards to reduce taxable income or taxes payable attributable to the other entity after the business combination. If the combined entity expects to file a consolidated tax return, an acquirer may determine that as a result of the business combination its valuation for its deferred tax assets should be changed. For example, the acquirer may be able to utilize the benefit of its tax operating loss carryforwards against the future taxable profit of the acquiree. In such cases, the acquirer reduces its valuation allowances based on the weight of available evidence. However, that reduction does not enter into the accounting for the business combination but is recognized as an income tax benefit (or credited directly to contributed capital [see paragraph 740-10-45-20]).
Acquired deferred tax liabilities could be a source of income to support recognition of acquired deferred tax assets or the acquirer’s existing deferred tax assets, or both. Accordingly, in circumstances in which some but not all of the combined deferred tax assets are supported by acquired deferred tax liabilities, the acquirer will need to determine which balances are being supported. We believe there are two acceptable accounting policies. One policy is to consider the recoverability of deferred tax assets acquired in the acquisition before considering the recoverability of the acquirer’s existing deferred tax assets. Another policy is to consider relevant tax law ordering rules for utilization of tax assets to determine whether the acquired or pre-existing deferred tax assets are considered realizable.
Example TX 10-12 illustrates the application of the alternative accounting policies on a valuation allowance assessment in acquisition accounting.
EXAMPLE TX 10-12
Accounting policy for considering whether acquired deferred tax liabilities support realization of acquired or acquirer’s deferred tax assets
Accounting policy for considering whether acquired deferred tax liabilities support realization of acquired or acquirer’s deferred tax assets
Company X and Company Y each have $2,000 of deferred tax assets related to net operating loss (NOL) carryforwards generated in the last four years. Other deferred tax assets and liabilities are de minimis. Company X has historically maintained a valuation allowance against its deferred tax assets. In the current period, Company X acquires the shares of Company Y in a nontaxable transaction and the combined business will file a consolidated tax return. As part of the acquisition, deferred tax liabilities of $1,500 related to Company Y are recorded. Although the earnings of the combined entity are not objectively verifiable, the acquired deferred tax liabilities will reverse prior to any NOL expirations and are, therefore, a source of future taxable income that can support the realization of deferred tax assets.
There are no tax law limitations on future realization of the NOL carryforwards. Consequently, Company X determines it needs a valuation allowance of $2,500 (combined deferred tax assets of $4,000 less reversing deferred tax liabilities of $1,500).
In Company X's financial statements, which deferred tax assets (i.e., acquirer’s or acquiree’s) are supported by the deferred tax liabilities recorded upon acquisition of Company Y?
Analysis
Deferred taxes are recorded in acquisition accounting for the acquired entity’s temporary differences and operating loss/credit carryforwards. However, any changes in the acquirer’s deferred taxes as a result of a business combination should be recorded currently in income.
In this fact pattern, we believe there are two alternative methods to account for the benefit that can be recognized in Company X’s financial statements:
View A—The deferred tax liabilities should first be considered as a source of taxable income in relation to the acquired company’s deferred tax assets, with any residual amount applied to the acquirer’s deferred tax assets. This view is premised on the sequence of events, starting with the acquisition, followed by the consideration of impacts on the acquirer. In this example, a $500 valuation allowance would be recorded in acquisition accounting (i.e., $1,500 of the $2,000 acquired deferred tax assets are expected to be realized), and there would be no recognition of the acquirer’s pre-existing deferred tax assets. The existing valuation allowance against the acquirer’s deferred tax assets ($2,000) would not change.
View B—Realization of the deferred tax assets should be based on underlying tax law ordering for the jurisdiction (e.g., looking first to older NOLs if that is consistent with the tax law in the relevant jurisdiction). The objective would be to determine the reversal pattern of tax attributes and deductible temporary differences under the tax law. However, when the order in which tax attributes and deductible temporary differences will be used is not determinable, the entity should develop a systematic, rational, and consistent methodology for allocating the benefit resulting from the deferred tax liabilities.
Either view is acceptable as an accounting policy election to be applied consistently. Appropriate financial statement disclosure should be made, including specific disclosure of any benefits or expenses recognized for changes in the acquirer’s valuation allowance.
10.5.5 Change to valuation allowance for acquired assets
The release of a valuation allowance that does not qualify as a measurement period adjustment is subject to the normal intraperiod allocation rules and is not part of acquisition accounting. The release of a valuation allowance within the measurement period resulting from new information about facts and circumstances that existed at the acquisition date is reflected first as an adjustment to goodwill, then as a bargain purchase.
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