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An acquirer may take positions in a taxable business combination (e.g., in allocating the acquisition price and in filing subsequent tax returns) that it expects the taxing authority to challenge. Similarly, there may be uncertainties about the tax basis of individual assets or the pre-acquisition tax returns of the acquired business in nontaxable business combinations. Both types of situations are considered to be uncertain tax positions. See TX 15 for more discussion of accounting for tax uncertainties.

10.6.1 Income tax indemnifications

ASC 805 provides guidance on the recognition and measurement of an indemnification asset and requires what is sometimes referred to as “mirror image” accounting for indemnifications. The indemnified party recognizes an indemnification asset at the same time that it recognizes the indemnified item and measures the asset on the same basis as the indemnified item. Accordingly, an indemnification asset related to an uncertain tax position is recognized at the same time and measured on the same basis as the related liability, subject to collectability or contractual limitations on the indemnified amount. The liability is recognized and measured using the ASC 740 guidance. Indemnification assets recognized on the acquisition date continue to be measured on the same basis as the related indemnified item until they are collected, sold, cancelled, or expire.
Mirror image accounting assumes that the terms of the indemnification arrangement fully cover the related exposure. When that is not the case, there can be accounting differences, such as in the following scenarios:
  • An income tax uncertainty relates to the timing of a deduction. For example, a tax deduction was claimed in year 1, but there is risk that the deduction should be taken over 15 years. When the indemnification covers the implied interest cost associated with spreading the deduction over a longer period, the indemnification asset would not equal the related liability. Rather, in this case, the indemnification receivable would presumably equal only the outstanding interest accrual.
  • The indemnification covers any tax exposure that exceeds a specified dollar amount. In this situation, the mirror image will apply only to the excess over the specified amount.
There also may be scenarios in which the terms of the indemnification fully cover the tax exposure, but the related amounts recorded for accounting purposes appear to differ, such as in the following scenarios:
  • A company does not classify interest and penalties in the same line as the liability for an income tax exposure. In this situation, mirror image accounting may apply (assuming that interest and penalties are covered by the indemnification); however, the indemnification asset would mirror the total of the tax liability and the related interest and penalty accruals.
  • The company records a reserve against the indemnification asset due to collection risk.
There may also be scenarios in which the seller provides a blanket indemnification for taxes owed in prior years, but no specific tax positions are reserved. If no liability is required under the uncertain tax position guidance in ASC 740, an indemnification asset should not be recognized. Accordingly, the indemnification asset would be zero, which is the mirror image of the tax liability.
Another scenario to consider is when the income tax uncertainty increases a loss carryforward. In this situation, the guidance in ASC 740 requires a net presentation (i.e., the company should not record a deferred tax asset for the loss carryforward and a liability for the tax uncertainty). However, if the tax liability is covered by an indemnification, the indemnification asset would mirror the tax liability even though no tax liability is recorded. For example, assume that a buyer acquires a $100 loss carryforward (tax-effected). The buyer determines that $20 of the loss carryforward is an unrecognized tax benefit and, therefore, reduces the loss carryforward to $80. If the seller indemnifies the buyer for the related tax exposure, the buyer would record a $20 indemnification asset.
Companies should ensure that liabilities for unrecognized tax benefits, regardless of whether covered by an indemnification agreement, are included in the company’s annual disclosures. That is, the disclosures required by ASC 740-10-50-15 would reflect the unrecognized tax benefits with no offset or netting for an indemnification. For example, the company would need to include the tax position in its disclosure of gross amounts of increases and decreases in unrecognized tax benefits and amounts that, if recognized, would affect the effective tax rate. However, it may often be necessary to provide additional disclosure in regard to the terms of any indemnification arrangements so that financial statement readers can appropriately assess the net economic exposure to the entity.
See BCG 2.5.14 and TX 15.8 for further information on indemnifications.

10.6.2 Changes in tax uncertainties after the business combination

Adjustments to uncertain tax positions made subsequent to the acquisition date are recognized in earnings, unless they qualify as measurement period adjustments. Measurement period adjustments are recorded first as an adjustment to goodwill, then as a bargain purchase.
A change in an income tax uncertainty that is based upon facts and circumstances that existed as of the acquisition date is recorded as a measurement period adjustment (as described in ASC 805-10-25-13 through ASC 805-10-25-14). For example, during the initial due diligence, the acquirer may have identified uncertain tax positions of the acquiree and made a preliminary estimate of the amount, if any, of the related liability. That preliminary estimate would be recorded in acquisition accounting. If, during the measurement period, the acquirer performs a more detailed analysis of information that existed at the acquisition date and determines that an adjustment is necessary, the adjustment should be recorded as a measurement period adjustment in the reporting period in which the adjustment amount is determined.
Similarly, if, during the measurement period, the acquirer discovers an uncertain tax position that was not identified in its due diligence, but which existed at the acquisition date, the accounting for that position should be recorded as a measurement period adjustment in the reporting period in which the adjustment amount is determined.
See TX 10.5.5 and BCG 2.9 for additional discussion of measurement period adjustments.
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