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Business combinations are sometimes completed in stages. When this occurs, entities may need to consider the accounting for holding gains and outside basis differences, the interplay of acquisition accounting and inside basis differences, and holding gains associated with partnerships.

10.6.1 Holding gains and outside basis differences (after adoption of ASU 2019-12)

An acquirer sometimes obtains control of an acquiree in which it held an equity interest prior to the acquisition date. In a business combination achieved in stages, the acquirer should remeasure its previously held equity interest in the acquiree at its acquisition date fair value and recognize the resulting gain or loss (i.e., the difference between its fair value and carrying value) in earnings. If changes in the fair value of the equity interest were previously recorded in other comprehensive income (OCI), the amount of unrealized gains or losses should be reclassified from OCI and included in the measurement of the gain or loss on the acquisition date. The recognition of a gain or loss at the acquisition date represents the recognition of the economic gain or loss that is present in the previously held equity interest.
Prior to obtaining control, any deferred taxes that needed to be recorded under ASC 740 would have been based on the difference between the carrying amount of the investment in the financial statements and the tax basis in the shares of the investment (i.e., outside basis difference). Unless a current tax is triggered, remeasuring the previously held equity interest to fair value will increase the book basis with no corresponding increase in the tax basis, thus changing the outside basis difference and associated deferred tax. Since the acquirer’s gain or loss from remeasuring the acquirer’s previously held investment is reflected in net income, the corresponding tax effect of the change in outside basis difference caused by such gain or loss should be reflected in the acquirer’s income tax expense from continuing operations. The gain or loss associated with a previously held equity interest might include the effects of reclassifying amounts from accumulated other comprehensive income to net income (e.g., unrealized gains or losses on available for sale securities and cumulative translation adjustment). Generally, the corresponding reclassification adjustment from OCI to net income will also include any related income tax expense or benefit that was previously recognized in OCI.
Upon obtaining control, the acquirer may no longer need to recognize deferred taxes on the outside basis of the investment under one of the exceptions in ASC 740-30-25 (e.g., there is a means for tax-free recovery of the investment). If the subsidiary is domestic and the parent has the intent and ability under the tax law to recover its investment in a tax-free manner (see TX 11.9.2.4) or if the subsidiary is foreign and the parent has asserted the indefinite reversal exception (see TX 11.9.2.1), the entire deferred tax liability related to the outside basis difference on the previously held investment is reversed. The effect of reversing the deferred tax is recorded in the acquirer’s income tax expense from continuing operations and does not impact acquisition accounting. The gain or loss associated with a previously held equity interest might include the effects of reclassifying amounts from accumulated other comprehensive income to net income. Generally, the corresponding reclassification adjustment to OCI will also include any related income tax expense or benefit that was recognized in OCI.
Example TX 10-13 illustrates the impact on the outside basis difference from remeasuring a previously held investment.
EXAMPLE TX 10-13
Impact on outside basis difference from remeasuring a previously held investment
Company A has a 20% equity-method investment in Company B with a carrying value of $1,000 and a tax basis of $800. Company A has recorded a corresponding deferred tax liability of $50 (($1,000 – $800) x 25%). Company A acquires the remaining 80% of Company B. The fair value of Company A’s previously held investment in Company B is $1,500 at the acquisition date.
Should Company A record the deferred taxes related to the outside basis difference in Company B as a result the acquisition, assuming Company A is not asserting indefinite reinvestment?
Analysis
Yes. Company A would remeasure its investment in Company B to $1,500 and record a gain of $500 for financial reporting purposes. Company A’s book versus tax basis difference in the previously owned shares of Company B would increase from $200 ($1,000 – $800) to $700 ($1,500 – $800) at the acquisition date. Assuming a 25% tax rate, Company A would record an entry to increase the deferred tax liability from $50 to $175. The $125 is calculated as the increase in outside basis difference of $500 x 25% tax rate.

10.6.1A Holding gains and outside basis differences (before adoption of ASU 2019-12)

An acquirer sometimes obtains control of an acquiree in which it held an equity interest prior to the acquisition date. In a business combination achieved in stages, the acquirer should remeasure its previously held equity interest in the acquiree at its acquisition date fair value and recognize the resulting gain or loss (i.e., the difference between its fair value and carrying value) in earnings. If changes in the fair value of the equity interest were previously recorded in other comprehensive income (OCI), the amount of unrealized gains or losses should be reclassified from OCI and included in the measurement of the gain or loss on the acquisition date. The recognition of a gain or loss at the acquisition date represents the recognition of the economic gain or loss that is present in the previously held equity interest.
Prior to obtaining control, any deferred taxes that needed to be recorded under ASC 740 would have been based on the difference between the carrying amount of the investment in the financial statements and the tax basis in the shares of the investment (i.e., outside basis difference). Unless a current tax is triggered, remeasuring the previously held equity interest to fair value will increase the book basis with no corresponding increase in the tax basis, thus changing the outside basis difference and associated deferred tax. Since the acquirer’s gain or loss from remeasuring the acquirer’s previously held investment is reflected in net income, the corresponding tax effect of the change in outside basis difference caused by such gain or loss should be reflected in the acquirer’s income tax expense from continuing operations. The gain or loss associated with a previously held equity interest might include the effects of reclassifying amounts from accumulated other comprehensive income to net income (e.g., unrealized gains or losses on available for sale securities and cumulative translation adjustment). Generally, the corresponding reclassification adjustment from OCI to net income will also include any related income tax expense or benefit that was previously recognized in OCI.
Example TX 10-13A illustrates the impact on the outside basis difference from remeasuring a previously held investment.
EXAMPLE TX 10-13A
Impact on outside basis difference from remeasuring a previously held investment
Company A has a 20% equity-method investment in Company B with a carrying value of $1,000 and a tax basis of $800. Company A has recorded a corresponding deferred tax liability of $50 (($1,000 – $800) x 25%). Company A acquires the remaining 80% of Company B. The fair value of Company A’s previously held investment in Company B is $1,500 at the acquisition date.
Should Company A record the deferred taxes related to the outside basis difference in Company B as a result the acquisition, assuming Company A is not asserting indefinite reinvestment?
Analysis
Yes. Company A would remeasure its investment in Company B to $1,500 and record a gain of $500 for financial reporting purposes. Company A’s book versus tax basis difference in the previously owned shares of Company B would increase from $200 ($1,000 – $800) to $700 ($1,500 – $800) at the acquisition date. Assuming a 25% tax rate, Company A would record the following tax entry to increase the deferred tax liability from $50 to $175. The $125 is calculated as the increase in outside basis difference of $500 x 25% tax rate.

Upon obtaining control, the acquirer may no longer need to recognize deferred taxes on the outside basis of the investment under one of the exceptions in ASC 740-30-25 (e.g., there is a means for tax-free recovery of the investment). In these cases, the accounting for the deferred tax related to the previously held investment depends on whether the subsidiary is foreign or domestic.
If the subsidiary is domestic and the parent has the intent and ability under the tax law to recover its investment in a tax-free manner, the entire deferred tax liability related to the outside basis difference on the previously held investment is reversed. The effect of reversing the deferred tax is recorded in the acquirer’s income tax expense from continuing operations and does not impact acquisition accounting. The gain or loss associated with a previously held equity interest might include the effects of reclassifying amounts from accumulated other comprehensive income to net income. Generally, the corresponding reclassification adjustment to OCI will also include any related income tax expense or benefit that was recognized in OCI.
If the subsidiary is foreign, then a portion of the deferred tax liability related to the outside basis difference on the previously held investment must generally be retained. ASC 740 requires that a deferred tax liability continue to be recorded for the temporary difference related to the investor’s share of the undistributed earnings of a foreign investee prior to the date it becomes a subsidiary. The deferred tax liability should remain as long as dividends from the subsidiary do not exceed the parent company’s share of the subsidiary’s earnings subsequent to the date it became a subsidiary (see ASC 740-30-25-16). Effectively, the deferred tax liability at the acquisition date for the outside basis temporary difference caused by undistributed earnings of the foreign investee is “frozen” until that temporary difference reverses.
Outside basis differences can arise from activities other than from undistributed earnings (e.g., currency translation adjustments). In such cases, it is unclear what portion of the deferred tax liability should be retained. One view is that upon gaining control of an investee, the deferred tax liability for the entire outside basis difference, including any basis difference resulting from adjusting the investment to fair value, is frozen until that temporary difference reverses. A second view is that only the portion of the deferred tax liability that relates to undistributed earnings of the investee as of the date control is obtained is frozen. In some jurisdictions, the recovery of an investment in a foreign equity investee does not have tax consequences to the investor. In those circumstances, a deferred tax liability for holding gains would not be recognized (and then frozen) when control is obtained as such gains would never be taxable and therefore do not constitute temporary differences.
New guidance
In December 2019, the FASB issued ASU 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes. This guidance removes exceptions to the general principles in ASC 740-30 that resulted in “frozen” outside basis differences for foreign equity method investments and subsidiaries.
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. The amendments should be applied through a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption.

10.6.2 Step-acquisitions and inside basis differences

Upon gaining control of the investee, the acquirer will apply acquisition accounting and recognize the assets acquired and liabilities assumed, including goodwill. The acquirer must then identify and measure associated deferred tax assets and liabilities. Consider a situation in which the acquiring company obtains a step-up in tax basis in the net assets acquired for the portion most recently purchased but does not obtain a step-up in tax basis for the portion previously held. The method for calculating tax bases would result in larger inside book-over-tax-basis differences as a result of the acquirer’s previously held investment, which, in turn, would impact the amount of goodwill recorded in acquisition accounting. Example TX 10-14 illustrates this concept.
EXAMPLE TX 10-14
Impact on inside basis differences from a previously held investment
Company A has a 20% equity-method investment in Company B, with a carrying value of $1,000 and a tax basis of $800. Company A acquires the remaining 80% of Company B for $8,000 and elects, under the tax law, to obtain a step-up of the inside tax bases of the net assets acquired for the 80% purchased (i.e., elected to treat the transaction as taxable). The fair value of the previously held 20% investment at the acquisition date is $2,000.
How should Company A record the deferred taxes on the inside basis differences in Company B as a result of the acquisition?
Analysis
The resulting inside tax bases would be a combination of the 20% carryover tax basis and the 80% fair value ($800 + $8,000 = $8,800).
For financial reporting, the net assets acquired would be recorded at fair value. The total net assets held, including goodwill, would be recorded at $10,000 ($8,000 consideration transferred for 80% implies fair value of $10,000 for 100%).
The aggregate book bases exceed the aggregate tax bases by $1,200 ($10,000 – $8,800). The excess would be attributable to the carryover inside tax bases resulting from the 20% previously held investment (fair value of 20% previously held investment less carryover tax bases $2,000 – $800 = $1,200). Therefore, a deferred tax liability generally would be recorded as part of acquisition accounting, although consideration would need to be given to the prohibition against recording a deferred tax liability on excess book over tax-deductible goodwill (see TX 10.8.3).

10.6.3 Holding gains and partnerships

An acquirer sometimes obtains control of a partnership in which it held an equity interest prior to the acquisition date. Example TX 10-15 illustrates the impact on the outside basis difference upon acquiring control of a partnership.
EXAMPLE TX 10-15
Deferred tax accounting on holding gains recognized when a company acquires control of a partnership
Company A owns a 50% noncontrolling interest in a US partnership and has a carrying value and tax basis of $100 and $80, respectively, which resulted in recognition of an outside-basis deferred tax liability of $5 (tax rate of 25% times outside basis difference of $20). In the current period, Company A acquires the remaining partnership interest for $150. The staged acquisition results in recognition of a holding gain of $50 because Company A's previously held equity interest is remeasured at fair value. (The $50 holding gain is calculated as the fair value of the previously held 50% (which would be the same as the purchased 50%) of $150 less its carrying value of $100.)
For US federal tax purpose, the partnership terminates when Company A becomes the sole owner of the entity (i.e., the acquired entity effectively becomes a taxable division of Company A). Consequently, Company A's outside basis in the partnership is no longer tax relevant and Company A would instead only account for inside basis differences. After the transaction, the book value of the acquired net assets is $300 ($150 for 50% implies $300 for 100%).
After the acquisition of the remaining 50%, there is nondeductible goodwill in the partnership of $10. The tax basis is $230 ($80 historical basis in 50% previously owned plus $150 in new tax basis from the acquisition). Therefore, the total inside basis temporary differences is $70 ($300 basis for financial reporting and $230 of tax basis). In accordance with ASC 805-740-25-9, no deferred taxes are recognized for the excess of financial reporting goodwill over the tax-deductible amount of goodwill at the acquisition date (refer to TX 10.8.3). Thus, the total inside basis difference of $70 is reduced by the $10 related to nondeductible goodwill. The remaining difference of $60 yields a deferred tax liability of $15 ($60 x 25%).
Should the deferred tax consequences of the purchase be recognized entirely in acquisition accounting or in income?
Analysis
The incremental deferred tax should be recognized in income. We believe that when a partnership terminates and becomes a taxable division of the owner, the outside tax basis simply "rolls" into the inside tax basis in individual assets and liabilities. It is not appropriate to reverse the incremental deferred tax into earnings only to re-establish it in acquisition accounting. Additionally, the tax charge is more appropriately connected to the deemed sale of the preexisting equity interest rather than the acquisition of the controlling interest. Since the gain on the deemed sale of the preexisting equity interest was recorded in the income statement, the related tax charge should be recorded in the income statement as well.
Because a deferred tax liability of $5 has already been recognized prior to the acquisition, a $10 deferred tax liability would be recognized in the period of the purchase of the remaining 50% and there would be no deferred tax effects in acquisition accounting since under this approach the entity has not recorded any tax effects of the non-deductible goodwill. This view would only be appropriate under a ‘look through’ approach (see TX 11.7).
An alternative view is that a deferred tax expense of $12.5 (25% of the “holding gain” of $50) should be recognized as if the preexisting interest had been sold for fair value consideration. In that case, because a deferred tax liability cannot be recognized for the nondeductible goodwill, the deferred tax liability would be reduced by $2.5 in acquisition accounting resulting in a corresponding reduction in goodwill.
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