Income taxes in business combinations

• Record deferred taxes for basis differences of assets acquired and liabilities assumed
• Apply the goodwill exception and the simultaneous equation for excess tax goodwill
• Route valuation allowance changes to goodwill or income tax expense correctly
• Distinguish stock acquisitions with carryover basis from asset acquisitions with stepped-up basis

Deferred taxes are part of the acquisition accounting

In a business combination, the acquirer measures identifiable assets and liabilities at fair value. Their tax bases depend on the deal structure. Statement 109 paragraph 30, as amended by Statement 141(R), requires the acquirer to recognize, as of the acquisition date, deferred tax liabilities and assets for the acquired entity's taxable and deductible temporary differences and its operating loss and tax credit carryforwards. Exceptions: the portion of goodwill whose amortization is not deductible for tax, leveraged leases, and certain outside basis differences.

Deferred taxes recognized at the acquisition date are part of net assets acquired, so they change goodwill. A net deferred tax liability increases goodwill; a net deferred tax asset decreases it.

Structure drives the basis

• Stock acquisition (carryover basis). The target's tax bases carry over. Fair value step-ups to intangibles, inventory and equipment have no tax basis, so they create deferred tax liabilities. Goodwill created in the deal has no tax basis, so no deferred tax is recorded on it.
• Asset acquisition or deemed asset sale (stepped-up basis). Tax bases are reset to the allocated purchase price, so book and tax bases are close and deferred taxes are small. Tax goodwill is amortizable.

The asset versus stock purchase guide covers the tax structuring side.

Goodwill in two components

When goodwill is deductible, Statement 109 paragraph 262 (as amended) splits book and tax goodwill into two components. The first component is the lesser of book goodwill and tax-deductible goodwill; later differences in that component are temporary differences. No deferred taxes are recognized for an excess of book goodwill over tax goodwill. If tax goodwill exceeds book goodwill, the excess is a temporary difference and a deferred tax asset is recognized at the acquisition date. Because that asset reduces book goodwill, which increases the difference, paragraph 263 solves it with a simultaneous equation:

Deferred tax asset = (tax rate / (1 - tax rate)) x preliminary temporary difference

Valuation allowances

• Acquired deferred tax assets. The acquirer assesses the need for an allowance at the acquisition date. Under paragraph 30A, changes within the measurement period that result from new information about facts that existed at the acquisition date adjust goodwill (and, once goodwill is zero, a bargain purchase gain). All other changes go to income tax expense.
• The acquirer's own deferred tax assets. If the acquisition changes the acquirer's assessment of its existing deferred tax assets (for example, the target's deferred tax liabilities now provide a source of taxable income), the change is recognized in income, not in acquisition accounting. ASC 740-10-50-9(h) lists these acquisition-date effects under ASC 805-740-30-3 as a component of tax expense.
• Limits on use. Paragraph 264 says the allowance assessment reflects tax law limits on using one combining entity's deductible temporary differences or carryforwards against the other's taxable income. Where the law limits the acquiree's attributes to the acquiree's own future income, the allowance is assessed on the acquiree's separate past and expected results.

The measurement period ends when the acquirer has the information it was seeking, and never exceeds one year from the acquisition date (Statement 141(R) paragraph 51).

Acquired tax uncertainties

Statement 141(R) paragraph 27 requires the acquirer to account for the acquiree's income tax uncertainties under Statement 109 and Interpretation 48. Statement 141(R) added paragraphs 12A and 12B to Interpretation 48: tax bases and amounts due to or from taxing authorities at the acquisition date are measured under Interpretation 48, measurement-period changes from new information about facts that existed at the acquisition date adjust goodwill, and all other changes are accounted for under Interpretation 48.

Audit focus

Tie the deferred tax computation to the purchase price allocation, confirm tax bases to the acquisition tax analysis, and test the rate used for each jurisdiction. The business combinations guide covers the rest of ASC 805.

Deferred taxes in two acquisitions by Westbrook Instruments, Inc.