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Goodwill for financial reporting purposes is a residual amount. Acquired goodwill for financial reporting purposes is recognized as an asset and is generally not amortized. Some business combinations, particularly taxable business combinations, can generate goodwill that is deductible for tax purposes (also referred to as “tax-deductible goodwill”).
The amount assigned to goodwill for book and tax purposes could differ, due to different valuation and allocation rules and differences in determining the amount of consideration transferred (e.g., different treatment of contingencies or costs incurred for the transaction). ASC 740 describes the separation of goodwill into components to assist in determining the appropriate deferred tax accounting related to goodwill at the acquisition date. The first component (component 1) equals the lesser of (1) goodwill for financial reporting or (2) tax-deductible goodwill. The second component (component 2) equals the remainder of each, that is, (1) the remainder, if any, of goodwill for financial reporting in excess of tax-deductible goodwill or (2) the remainder, if any, of tax-deductible goodwill in excess of the goodwill for financial reporting (ASC 805-740-25-8).
Figure TX 10-2 displays the concept of component-1 and component-2 goodwill.
Figure TX 10-2
Goodwill components

10.8.1 Business combinations in multiple jurisdictions

Business combinations may involve multiple jurisdictions (or multiple tax-paying components within a jurisdiction). Tax-deductible goodwill in each jurisdiction will need to be compared to book goodwill allocated to each jurisdiction to determine the related temporary differences. ASC 740-10-30-5 requires that deferred taxes, including goodwill, be determined separately for each tax-paying component (an individual entity or group of entities that are consolidated for tax purposes) in each jurisdiction. ASC 350, Intangibles-Goodwill and Other, generally requires goodwill for financial reporting purposes to be assigned to reporting units. As part of the assignment to reporting units, the book goodwill may also be identified as being associated with a particular jurisdiction (see BCG 9.2). Because the assignment of goodwill for book and tax purposes are governed by different guidance, the reporting units to which goodwill is assigned under ASC 350 may not align with the tax-paying components for tax purposes (e.g., a reporting unit might consist of more than one tax-paying component or a tax-paying component might exist across more than one reporting unit). We believe that goodwill for financial reporting should be allocated to tax-paying components and tax-deductible goodwill for tax-paying components should be allocated to reporting units on a systematic and rational basis that is consistently applied. Once goodwill has been allocated, the tax-deductible goodwill in each tax-paying component will need to be compared to book goodwill allocated to each tax-paying component for purposes of separating goodwill into component -1 and component -2.
Example TX 10-16 illustrates goodwill allocation for a reporting unit with more than one tax-paying component.
EXAMPLE TX 10-16
Comparison of book goodwill to tax-deductible goodwill involving multiple jurisdictions
Company A buys Subsidiary B in a nontaxable business combination. Subsidiary B has operations in the US and Germany. As a result of the transaction, Company A recorded $600 of book goodwill. Subsidiary B represents a new reporting unit and Company A determines $500 of the book goodwill is associated with US operations, while the remaining $100 relates to German operations. Carryover tax-deductible goodwill acquired in the transaction is $500; $200 is associated with legal entities in the US and $300 is associated with legal entities in Germany.
What are the book and tax-deductible goodwill of Subsidiary B?
Analysis
Goodwill at a jurisdictional level would be as follows:
US goodwill
German goodwill
Book
Tax
Book
Tax
Component-1
$200
$200
$100
$100
Component-2
300
200
Total goodwill
$500
$200
$100
$300
At the acquisition date, the acquirer would not record a deferred tax liability for goodwill associated with the US jurisdiction because book goodwill exceeds the tax-deductible goodwill. However, for goodwill associated with the German jurisdiction, the acquirer would record a deferred tax asset in acquisition accounting because tax-deductible goodwill exceeds book goodwill (see TX 10.8.2.1 for further discussion of measuring the deferred tax asset).

10.8.2 Excess of tax-deductible goodwill over book goodwill

An excess of tax-deductible goodwill over goodwill for financial reporting is a temporary difference for which a deferred tax asset is recognized.
In a nontaxable transaction when the historical tax bases of the acquired business carry over to the acquirer, there may be tax-deductible goodwill from prior acquisitions of the acquiree that carries over in the current acquisition. In this instance, a question arises as to how to treat the carryover tax-deductible goodwill in determining deferred taxes. We believe that the carryover tax-deductible goodwill should be compared to the book goodwill arising in the current transaction for purposes of determining whether a recognizable temporary difference exists.
In analyzing component-1 and component-2 goodwill, the expected impact on tax-deductible goodwill of assumed liabilities, contingent liabilities, and contingent consideration should be considered. See TX 10.4.5 for further information on the comparison of book goodwill to tax-deductible goodwill when there are assumed liabilities, contingent liabilities, or contingent consideration. See TX 10.4.7 for further information on the treatment of acquisition-related costs in the comparison of book goodwill to tax-deductible goodwill.

10.8.2.1 Deferred tax asset for excess tax-deductible goodwill

ASC 805 prescribes the recognition of a deferred tax benefit resulting from tax-deductible goodwill that is in excess of book goodwill. The tax benefit of the excess tax goodwill is recognized as a deferred tax asset at the acquisition date, which increases the values assigned to the acquired net assets and correspondingly decreases book goodwill. This, however, further increases (1) the difference between book goodwill and tax-deductible goodwill and (2) the corresponding deferred tax balance (as described in ASC 805-740-55-9 through ASC 805-740-55-13). To deal with this iterative process, the computation of the deferred tax asset can be reduced to the following simultaneous equation:
(Tax rate / (1 – tax rate)) × preliminary temporary difference (PTD) = deferred tax asset
The resulting amount of deferred tax asset reduces book goodwill. If book goodwill is reduced to zero, any additional amounts recognized will result in a bargain purchase gain. Example TX 10-17 provides an example of the iterative calculation.
EXAMPLE TX 10-17
Recording a deferred tax asset for excess tax-deductible goodwill, no bargain purchase gain
A taxable acquisition results in initial book goodwill of $450 million. A separate determination for taxes results in tax-deductible goodwill of $600 million. The gross preliminary temporary difference between book and tax goodwill is $150 million. The applicable tax rate is 25%.
How should the deferred tax asset for excess tax-deductible goodwill be determined?
Analysis
The deferred tax asset for the excess tax-deductible goodwill is (in millions):
(25% / (1 – 25%)) × $150 = deferred tax asset of $50
The acquirer would record a deferred tax asset for $50 million with a corresponding decrease in book goodwill. Therefore, final goodwill for financial reporting purposes would be $400 million, and a deferred tax asset of $50 million would be established. The resulting deferred tax asset appropriately reflects the temporary difference related to goodwill, as illustrated below (in millions):
(Tax goodwill – book goodwill) × 25% = deferred tax asset
($600 – $400) × 25% = $50

10.8.2.2 Nuances associated with the iterative formula

Use of the equation described in TX 10.8.2.1 is not appropriate in every situation. Complexities may arise that require modification of the formula and, in some cases, preclude its use altogether. These complexities may include the following situations:
  • The formula uses a single statutory tax rate. However, there may be situations when the temporary differences arising in the acquisition would be tax-effected at different rates (e.g., when there are different rates in a carryback period or a rate change has been enacted for future years, or where the temporary differences give rise to more than one type of taxable income). In these situations, successive calculations may be required to determine the deferred tax asset.
  • To the extent that a valuation allowance is required for all or part of the deductible temporary differences, there may be no or only a partial iterative effect on goodwill. Again, successive calculations may be required to determine the deferred tax asset.
Example TX 10-18 illustrates a situation in which the formula used to determine the deferred tax asset related to excess tax-deductible goodwill requires modification.
EXAMPLE TX 10-18
Recording a deferred tax asset for excess tax-deductible goodwill with bargain purchase gain
A taxable acquisition results in initial book goodwill of $120 million and tax-deductible goodwill of $600 million. The gross preliminary temporary difference (PTD) between book and tax goodwill is $480 million. Assume an applicable tax rate of 25%.
How should the deferred tax asset for excess tax-deductible goodwill be determined and recorded?
Analysis
The initial calculation of the deferred tax asset for excess tax-deductible goodwill is (in millions):
(25% / (1 – 25%)) × $480 = deferred tax asset of $160
However, the deferred tax asset is in excess of book goodwill. Recording a deferred tax asset of $160 million would result in a complete elimination of the book goodwill and a tax benefit of $40 million. In this case, the deferred tax asset would not appropriately reflect the temporary difference related to goodwill, as illustrated here (in millions):
(Tax goodwill – book goodwill) x 25% = deferred tax asset
($600 – $0) × 25% = $150, which does not equal the $160 deferred tax asset previously calculated
The following formula can be used to determine the amount of PTD which would eliminate all book goodwill (in millions):
(25% / (1 – 25%)) × PTD = $120 (book goodwill)
Solving for PTD = $360
A deferred tax asset would be recorded and goodwill would be adjusted to the extent of the calculated limit of PTD, calculated as follows (in millions):
(25% / (1 – 25%)) × $360 = $120
The remaining amount of deferred tax asset would be recorded as a bargain purchase gain. The following formula can be used to determine the amount of the gain (in millions):
(PTD original result – PTD revised limit) x 25% = gain
($480 – $360) × 25% = $30
When the initial calculation of the deferred tax asset related to goodwill exceeds the amount of book goodwill, the total deferred tax asset to be recognized will be equal to the tax effect of tax-deductible goodwill (i.e., tax-deductible goodwill less book goodwill of zero). Therefore, the company will record a deferred tax asset of $150 million (i.e., ($600 million tax goodwill - $0 book goodwill) x 25%). A portion of the deferred tax asset recognized in acquisition accounting will reduce initial book goodwill to zero.
The remaining amount of the deferred tax asset is recorded as a bargain purchase gain.
The following entry would be recorded (in millions):
Dr. Deferred tax asset
$150
Cr. Goodwill
$120
Cr. Bargain purchase gain
$30
The resulting deferred tax asset appropriately reflects the temporary difference related to goodwill, as illustrated below (in millions):
(Tax goodwill – book goodwill) × 25% = deferred tax asset
($600 – $0) × 25% = $150

10.8.2.3 Changes to deferred taxes for component-2 tax goodwill

In periods subsequent to the acquisition, when component-2 goodwill is an excess of tax-deductible goodwill over book goodwill, future changes in the tax or book goodwill balances will impact the deferred tax balance associated with goodwill. When goodwill is amortized for tax purposes or reduced for book purposes through impairment or amortization (under ASC 350-20-35-63), the result should be a corresponding adjustment to the temporary difference. For example, future amortization of tax-deductible goodwill will reduce the corresponding deferred tax asset until the tax basis is equal to the book basis and create a deferred tax liability for the basis difference created by tax amortization thereafter (see ASC 805-740-25-9). In situations where there is a book goodwill impairment and goodwill is tax deductible, the goodwill impairment must be allocated between component-1 and component-2 book goodwill. See BCG 9.9.6 for a discussion of the allocation of a goodwill impairment to the different components for tax purposes, including examples that illustrate the accounting in various scenarios
Refer to TX 10.8.3 for discussion of the accounting subsequent to the acquisition when component-2 goodwill is an excess of book goodwill over tax-deductible goodwill.

10.8.3 Excess of book goodwill over tax-deductible goodwill

When there is an excess of book goodwill over tax goodwill as of the acquisition date, no deferred tax liability is recorded for the excess book goodwill. Establishing a deferred tax liability would further increase the amount of goodwill, as it would decrease the value of the net assets acquired. This would, in turn, require an increase in the deferred tax liability, which would again increase goodwill, etc. As a consequence, it would result in the grossing up of goodwill and the deferred tax liability. As such, in accordance with ASC 740-10-25-9, no deferred tax liability is recorded at the acquisition date or in future years for the excess of book goodwill over the tax-deductible amount of goodwill. Subsequent changes related to the component-2 book goodwill (typically resulting from a book goodwill impairment or amortization of goodwill under the private company alternative (see TX 10.8.4)) are considered a permanent difference in the tax provision.
In contrast, in periods subsequent to the acquisition, a change in the book or tax basis of component-1 goodwill would yield a deferred tax asset or liability. This may occur due to amortization of tax-deductible goodwill, or due to reductions to book basis from impairment or book goodwill amortization under the private company alternative (see TX 10.8.4). Refer to TX 10.8.2.3 for discussion of the deferred tax accounting for a book goodwill impairment or amortization.
Deferred tax liabilities associated with goodwill may or may not serve as a source of income for purposes of realizing deferred tax assets. See TX 5.5.1 for more information.

10.8.4 Private companies–alternative accounting for goodwill

ASC 350-20-35-63 provides private companies with an accounting alternative to amortize goodwill on a straight-line basis over ten years, or less than ten years if the company demonstrates that another useful life is more appropriate. However, this alternative does not impact whether the goodwill is component-1 or component-2, nor does it impact the income tax accounting requirements for recording deferred taxes as a result of, and subsequent to, a business combination.
Companies that elect to apply the goodwill alternative may have to consider the potential effect on their valuation allowance assessment. See TX 5.5.2.

10.8.5 Deferred tax considerations in goodwill impairment testing

Goodwill is allocated to organizational units called reporting units for financial reporting purposes. BCG 9.3.5 includes considerations for assigning specific assets or liabilities to a reporting unit, including separate discussions and examples related to assigning net operating losses (NOLs), credit carryforwards, and other deferred taxes to reporting units.
Goodwill is also subject to periodic and trigger-based impairment tests. See BCG 9.5 for a detailed discussion of goodwill impairment. Additionally, BCG 9.9.1 discusses how an entity should consider deferred tax balances that relate to differences between the book and tax bases of assets and liabilities assigned to reporting units when testing for goodwill impairment. Specific considerations include how deferred taxes impact a reporting unit’s fair value and carrying amount when performing a goodwill impairment test.

10.8.6 Tax accounting–disposal of goodwill

In many jurisdictions, goodwill is associated with the stock of a specific legal entity, whereas for book purposes, goodwill is associated with a reporting unit. The reporting unit may include several legal entities or be limited to a portion of a legal entity. This can result in differences between the book and tax accounting for goodwill upon the disposal of a business.
If the disposed business is a legal entity, any tax-deductible goodwill associated with that entity would be included in the determination of the taxable gain or loss. If the disposed operations are a business, ASC 350-20-40-3 requires the allocation of a reporting unit’s goodwill to (1) the business that was disposed of and (2) the remaining parts of the reporting unit, based on their relative fair values on the date of disposal. Once goodwill is characterized as component-1 or component-2, it retains this characterization as long as a reporting entity retains that goodwill. Therefore, upon disposal of a business that includes some or all of a reporting entity’s goodwill, a deferred tax adjustment would generally be required for disposal of component-1, but not for disposal of component-2 goodwill. Example TX 10-19 and Example TX 10-20 illustrate the disposal of a business, including a portion of component-1 goodwill, resulting in a deferred tax adjustment to the reporting entity.
Example TX 10-21 illustrates the disposal of a business, including a portion of component-2 goodwill, resulting in no deferred tax adjustment to the reporting entity.
EXAMPLE TX 10-19
Disposal of tax-deductible goodwill with retention of book goodwill
Entity A acquired Entity B in a taxable business combination (i.e., Entity A treated the purchase as an asset acquisition for tax purposes), which gave rise to book and tax-deductible goodwill in equal amounts of $100. The business of Entity B and the associated goodwill are fully integrated into one of Entity A’s reporting units.
In a later period, Entity A decides to dispose of the shares of Entity B, including Entity B’s operations. For tax purposes, the entire remaining tax-deductible goodwill of $70 ($100 initial basis less assumed tax amortization of $30) is included in the disposal. For book purposes, assume goodwill of $20 should be allocated to the disposed operation on a relative fair value basis. As a result, $80 of the book goodwill is retained by the surviving reporting unit within Entity A ($100 initial value less $20 included in the disposed operation).
What is the deferred tax effect of a disposal of tax-deductible goodwill with a retention of book goodwill?
Analysis
The disposal would result in a basis difference in the goodwill retained by Entity A, with book goodwill exceeding tax-deductible goodwill by $80. This would give rise to a deferred tax liability for the entire $80 taxable basis difference (i.e., Entity A would compare nil tax-deductible goodwill to book goodwill of $80) because book goodwill remains component-1 goodwill consistent with the initial determination made at the acquisition date.
EXAMPLE TX 10-20
Disposal of book goodwill with retention of tax-deductible goodwill
Entity A acquired Entity B in a taxable business combination (i.e., Entity A treated the purchase as an asset acquisition for tax purposes), which gave rise to book and tax-deductible goodwill in equal amounts of $100. The business of Entity B and the associated goodwill are fully integrated into one of Entity A’s reporting units.
In a later period, Entity A decides to dispose of a significant portion of its operations but not its shares in Entity B. For tax purposes, there is $70 of tax-deductible goodwill remaining ($100 initial basis less assumed tax amortization of $30). The tax-deductible goodwill associated with the shares of Entity B would remain with Entity A. For book purposes, assume $80 of goodwill is allocated to the disposed operations on a relative fair value basis and included in the determination of the disposal gain or loss. Book goodwill of $20 remains in the reporting unit.
What is the deferred tax effect of a disposal of book goodwill with a retention of tax-deductible goodwill?
Analysis
The disposal of component-1 goodwill will result in a basis difference in goodwill retained by Entity A, consisting of the remaining tax goodwill ($70) exceeding book goodwill ($20) by $50, which will give rise to a deferred tax asset (subject to the measurement criteria of ASC 740). This is a result of book goodwill remaining component-1 goodwill consistent with the initial determination made at the acquisition date.
EXAMPLE TX 10-21
Evaluating deferred tax assets for temporary differences on component-2 goodwill after disposition of the entity that generated the goodwill
Entity A acquired Entity B in a nontaxable business combination. For tax purposes, the transaction resulted in a carryover basis in Entity B’s assets and liabilities. Because the tax basis carried over and Entity B’s assets for tax purposes did not contain any tax-deductible goodwill, all of the goodwill recorded in acquisition accounting ($500) was component-2 book goodwill (as defined in ASC 805-740-25-9).
Entity A has three reporting units. Entity A’s reporting unit composition is as follows:
The component-2 goodwill from the acquisition of Entity B was all allocated to Reporting Unit 2.
In the current year, Entity A sold Business 3, which includes Entity B. The goodwill in Reporting Unit 2 was allocated to Business 3, based on the relative fair value of Business 3 and the retained operations of Reporting Unit 2, pursuant to ASC 350-20-40-3. This resulted in only $100 of book goodwill being allocated to the business sold (Business 3).
Should Entity A record a deferred tax liability on the book to tax difference of $400 associated with the remaining book goodwill of Entity B in Reporting Unit 2 subsequent to the sale of Entity B?
Analysis
No deferred tax liability should be recognized in this instance. On the date Entity A acquired Entity B, the entire amount of book goodwill would have been classified as component-2 goodwill as there was no tax goodwill in the transaction, and no deferred tax liability was recorded pursuant to ASC 740-10-25-3(d). The fact that only a portion of that goodwill was subsequently attributed to Entity B when it was disposed of does not change that component-2 characterization. Thus, the goodwill remaining in Reporting Unit 2 after the sale of Entity B would continue to be component-2 goodwill, for which no deferred tax liability would be recorded.

10.8.7 Tax accounting–bargain purchase

Bargain purchase refers to a situation in which the fair value of the net assets acquired exceeds the fair value of consideration transferred. Such excess is sometimes referred to as “negative goodwill.” In these situations, the acquirer must reassess whether it has correctly identified all of the assets acquired and liabilities assumed and review the procedures used to measure the components of the acquisition to ensure all available evidence as of the acquisition date has been considered. When the aggregate amount of fair value assigned to the acquired net assets exceeds the acquisition consideration, it results in a bargain purchase gain (which is discussed in ASC 805-30-25-2). See BCG 2.6.2 for more information on accounting for a bargain purchase.
The tax rules for each separate jurisdiction may require a different treatment for bargain purchases than that required under ASC 805. Tax rules often require the allocation of negative goodwill to certain assets through the use of the residual method, resulting in decreased tax bases. In the United States, for example, for tax purposes, the acquisition price is assigned to assets categorized in seven distinct asset classes, first to the assets in Class I and then successively through to Class VII. The consideration transferred is not allocated to a successive class until it has been allocated to the assets in the previous class based on their full fair values. This methodology can result in several classes of assets without tax bases and in temporary differences for a significant portion of all assets. The allocation of negative goodwill to reduce the tax bases of acquired net assets causes the book bases to exceed their respective tax bases, resulting in the recognition of deferred tax liabilities.
Deferred taxes are recognized as part of the identifiable assets acquired and liabilities assumed. Therefore, the amount of the financial statement bargain purchase gain is directly affected by any such deferred taxes. See Example TX 10-19 for a situation where the recording of a deferred tax asset related to goodwill causes a bargain purchase gain. While not directly addressed in ASC 805, we believe the gain should be presented on a single line in pre-tax income from continuing operations. The deferred taxes included in the determination of the bargain purchase gain should not be shown on the income tax line (i.e., the bargain purchase gain should not be grossed-up to exclude deferred taxes). Therefore, the recognition of deferred tax liabilities results in a reduction in the bargain purchase gain for financial reporting and may result in the recognition of goodwill. Example TX 10-22 illustrates the recording of deferred tax balances in a bargain purchase situation.
EXAMPLE TX 10-22
Recording deferred tax balances in a bargain purchase (US tax jurisdiction)
Company A acquires Company B in a taxable acquisition. Total acquisition consideration amounted to $230 million, and the acquired fair value of the net assets equals $290 million, which results in the following allocation (in millions). The applicable tax rate is 25%.
Fair value
Tax basis
Class I – Cash
$50
$50
Class II – CDs
10
10
Class III – Accounts receivable
60
60
Class IV – Inventory
80
80
Class V – Tangible property
50
30
Class VI – Intangibles
40
0
Class VII – Goodwill
0
0
$290
$230
Tangible property consists of three pieces of equipment, as follows (in millions):
Fair value
Tax basis
Equipment A
$10
$6
Equipment B
15
9
Equipment C
25
15
$50
$30
For financial statement purposes, this transaction is a bargain purchase. Therefore, the assets are recorded at their fair value determined under the ASC 805, and the bargain element of the transaction is recorded in earnings.
How should deferred taxes be recorded in a bargain purchase?
Analysis
The differences between the book and tax bases of the net assets acquired result in the recognition of deferred tax liabilities of $15 million (($290 million – $230 million) x 25% tax rate). Therefore, the total amount of net assets recorded in acquisition accounting is $275 million ($290 million – $15 million). The bargain purchase gain would be calculated as follows (in millions):
Fair value of net assets acquired
$275
Less: consideration transferred
(230)
Bargain purchase gain
$45
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