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10.6 Business combinations achieved in stages
Publication date: 31 Mar 2023
us Income taxes guide
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
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
Impact on outside basis difference from remeasuring a previously held investment
Company A has a 20% equity-method investment in Company B, a foreign entity, 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 of 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.
10.6.2 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
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 in stages
Deferred tax accounting on holding gains recognized when a company acquires control of a partnership in stages
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 (outside basis difference of $20 times the 25% tax rate). 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 purposes, 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%), which includes non-deductible goodwill of $10 that arose from the transaction. The tax basis is $230 ($80 predecessor plus $150 new tax basis from the acquisition). Therefore, the total inside basis temporary difference is $70 ($300 basis for financial reporting less $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 times the tax rate of 25%), $5 which had previously been recorded plus an incremental $10 deferred tax liability that needs to be recorded.
How should the deferred tax consequences of the purchase be accounted for? Should the incremental deferred tax expense 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. Further, the tax charge in this case is more appropriately connected to the deemed sale of the pre-existing equity interest rather than the acquisition of the controlling interest.
In measuring the incremental deferred tax, we believe there are two acceptable measurement treatments that can be applied as an accounting policy choice:
Alternative 1: Consider how much non-deductible goodwill will arise in acquisition accounting and record the incremental deferred tax liability of $10 in tax expense. This view is supported by analogizing to the guidance allowing for a "look through" approach to measuring outside basis deferred taxes in a partnership interest (see TX 11.7).
Alternative 2: Recognize in income the incremental deferred tax expense of $12.50 (using the 25% tax rate) due on the holding gain of $50, which brings the total deferred tax liability recorded to $17.50 ($5 had been previously recorded). The premise of this view is that tax expense should be recognized as if the pre-existing interest had been sold for fair value consideration. However, because a deferred tax liability cannot be recognized for the non-deductible goodwill, the ending deferred tax liability cannot be more than $15. Therefore, goodwill is reduced to the extent of the deferred tax liability that cannot be recognized for the non-deductible goodwill ($2.50).
Had the partnership not terminated, for example if a subsidiary of Company A had acquired the remaining 50%, the deferred tax accounting would depend upon whether the company had a look through policy election.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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