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17.13 Stock-based compensation exchanged in business combinations
Publication date: 31 Dec 2022
us Income taxes guide
The acquirer in a business combination may agree to assume existing compensation arrangements of the acquiree or may establish new arrangements to compensate for postcombination vesting. Such arrangements should be analyzed to determine whether they represent compensation for precombination or postcombination services which will determine if they are accounted for as part of the consideration transferred for the acquiree, separate from the business combination, or both. In accordance with ASC 805-30-30-9, if the acquirer is obligated to grant the replacement award (e.g., by the terms of the acquisition or award agreements, or due to the applicable laws or regulations), the fair value of the award should be allocated between the portion related to precombination services, which should be included in the consideration transferred in the business combination, and postcombination services, which will be recognized as compensation cost. In accordance with ASC 805-740-25-10, for replacement awards that ordinarily result in a postcombination tax deduction, the acquirer should establish a deferred tax asset in acquisition accounting for the deductible temporary difference that relates to the portion of the fair value of a replacement award attributed to precombination services. This deferred tax asset represents a future tax benefit that the acquirer has obtained the right to receive as a result of the acquisition. For the fair value of a replacement award that is attributed to postcombination vesting and therefore is accounted for separate from the business combination, a deferred tax asset should be recorded in the postcombination financial statements as the related compensation cost is recognized as the service period is completed.
In accordance with ASC 805-30-30-10, if the acquirer grants replacement awards (but is not obligated to do so), the entire fair value of the award should be recognized as compensation cost in the postcombination financial statements. As a result, the related deferred tax benefit for the establishment of the deferred tax asset should be recognized in the postcombination tax provision of the acquirer.
In some situations, a discretionary acceleration of a stock-based compensation award is made at the time of acquisition and is deemed to be for the benefit of the acquirer; thus, a portion of the award value is allocated as compensation cost in the postcombination period for book purposes. However, for tax purposes, the compensation and related deduction may be on the seller’s precombination tax return. This would result in a deferred tax expense recorded in the acquiree’s precombination tax provision. The related deferred tax liability would carry over to the opening balance sheet and reverse in the successor period as the compensation expense is recognized for book purposes.
17.13.1 Equity-classified awards that result in a tax deduction
As noted above, a deferred tax asset should be recorded at the acquisition date for replacement awards that ordinarily result in a tax deduction and are included in the consideration transferred for the acquiree. The resulting income tax effects of equity-classified awards (e.g., stock options or restricted shares) exchanged in a business combination should be accounted for in accordance with ASC 718-740. If the ultimate tax deduction received by the acquirer upon the exercise of stock options or vesting of restricted shares is different than the sum of the fair value of the award included in the purchase price plus the cumulative book compensation cost recorded by the acquirer post acquisition (if any), the difference should be recognized in income tax expense in the income statement. No adjustment to goodwill or acquisition accounting is appropriate.
For example, if a partially vested replacement award is granted on the acquisition date, a deferred tax asset would only be recorded for the portion of the award’s fair value that was attributed to pre-combination services. A deferred tax asset related to the portion of the awards’ fair value attributed to post-combination services would be recorded in the post-combination financial statements as the service period is completed. In other words, for the portion of the awards’ fair value attributed to post-combination services, there are no adjustments to goodwill for the deferred tax asset related to awards attributed to post-combination services.
Example TX 17-4 illustrates this guidance; however, it does not consider the par value of the common stock issued or cash received for the option’s exercise price.
EXAMPLE TX 17-4
Income tax accounting for a partially vested equity-classified nonqualified option
Income tax accounting for a partially vested equity-classified nonqualified option
Company A (the acquirer) exchanges replacement awards in its equity having a fair value of $50 at the acquisition date for awards in Company B’s (the acquiree) equity with a fair value of $50. Company A was obligated to issue replacement awards under the terms of the acquisition agreement. When granted, Company B’s awards had a service period of four years. As of the acquisition date, three years of service required by the original terms of Company B’s awards have been rendered. The replacement awards have the same terms as the original awards. The awards are nonqualified options and, therefore, are expected to result in a tax deduction upon exercise of the awards. The exercise price of the awards is $30. Company A’s applicable tax rate is 25%. All of the awards are exercised two years after the acquisition date when the market price of Company A’s shares is $90.
What are the journal entries to record the replacement awards in acquisition accounting, the effects of post-combination services, and the income tax effects of the settlement upon exercise?
Analysis
As of the acquisition date, 75% (3 years pre-combination service / 4 years total service) of the fair value of the awards is attributable to pre-combination services. The replacement awards had no excess fair value over the acquiree awards; therefore, $37.5 ($50 × 75%) would be included in the consideration transferred for the acquiree:
Dr. Net assets acquired (e.g., goodwill) |
$37.5 |
|
Cr. APIC |
$37.5 |
Company A would also record a deferred tax asset for the portion of the awards attributed to pre-combination services equal to $9.4 ($37.5 × 25% tax rate) because the awards are expected to result in a tax deduction:
Dr. Deferred tax asset |
$9.4 |
|
Cr. Net assets acquired (e.g., goodwill) |
$9.4 |
One year after the acquisition date, the remaining year of service is completed, resulting in the vesting of the replacement awards. Company A would record compensation cost of $12.5 ($50 × 25%) in the post-combination financial statements for the remaining 25% of the fair value of the awards. A deferred tax benefit of $3.1 would also be recorded for the related increase in the deferred tax asset ($12.5 × 25% tax rate).
Upon exercise of the awards, Company A would be entitled to a tax deduction of $60 ($90 market price of Company A's shares – $30 exercise price). The tax benefit of the tax deduction would be $15 ($60 × 25%). The excess tax benefit of $2.50 (total tax benefit of $15 – deferred tax asset of $12.5) would reduce income tax expense in the income statement.
17.13.2 Liability-classified awards that result in a tax deduction
For liability-classified awards, the income tax accounting for awards exchanged in a business combination is similar to that for equity-classified awards. If the acquirer is obligated to grant the replacement award, the fair value of the award and the deferred tax asset related to pre-combination services should be included in the consideration transferred for the acquiree. Under the business combination guidance in ASC 805-30-55-13, all changes in the fair value of liability-classified awards after the acquisition date and the related income tax effects are recognized in the post-combination financial statements of the acquirer in the period in which the change occurs.
17.13.3 Awards that do not ordinarily result in a tax deduction
For awards that do not ordinarily result in a tax deduction (e.g., ISOs) for which the award’s fair value was attributed to pre-combination services, the acquirer should not recognize a deferred tax asset at the acquisition date because the awards are not expected to result in a tax benefit. In some situations, the acquirer may receive a tax deduction due to events that occur after the acquisition date (e.g., the disqualifying disposition of an ISO). Under ASC 805-740-25-11, the tax effect of a disqualifying disposition should be recognized in the income statement when it occurs.
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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