2016-Issue 15 – If Jimmy Fallon had a tax background and were to write one of his thank-you notes for this topic, it might read “Thank you, purchase accounting, because regular accounting for income taxes wasn’t complicated enough.”
Accounting for business combinations under Accounting Standards Codification (ASC) 805, Business Combinations, and the related purchase accounting considerations from an income tax accounting perspective are not for the faint of heart. When companies go through mergers or acquisitions, we are forced to deal with the mechanics of purchase accounting, including the tax accounting aspects. A keen understanding of these standards, particularly the income tax accounting components, is paramount in the preparation of your company’s income tax provision for financial reporting purposes. This edition of Tax Advisor Weekly examines the following tax accounting aspects as well as items to consider in purchase accounting. These items are some of the more common ones that have a significant impact on various tax positions and, ultimately, the company’s financial statements, yet all too often they are either overlooked or misapplied.
1. Asset versus Stock Deal
A tax professional’s initial question in business combinations is usually about the type and nature of the transaction. That is, did your company purchase the assets or the shares / stock of the other company? In addition, did your company make an IRC Section 338 election to treat your stock deal as an asset acquisition for tax purposes? While much effort and negotiation goes into this answer on the front end, it also serves as a starting point for various tax considerations on the back end when the effects of purchase accounting must be analyzed and recorded.
In an asset deal (including those where a Section 338 election is made), the purchaser typically enjoys a step-up to the fair market values (FMVs) of the assets acquired. Generally this is beneficial, as the taxpayer essentially receives a reset in value for, say, fixed assets that is typically higher than the existing tax basis of such fixed assets. In addition, the purchaser generally is able for tax purposes to amortize over a 15-year period amounts allocated to certain intangibles (i.e., customer lists, patents / trademarks, etc.) as set forth in the purchase agreement and/or valuation report. (Taxpayers should keep in mind, however, the importance of utilizing the appropriate purchase price allocation, whether that as outlined in the purchase agreement or that as reflected in the valuation report.) For more information on purchase price allocations, see Issue 35-2013, “Purchase Price Allocations — Get It Right Up Front!”
As an example, say Holdco A acquires the assets of Company B. Holdco A pays $100 for the assets, $70 of which is assigned to the value of machinery and equipment, $10 for customer lists, and the residual $20 to goodwill. Let’s also assume that Company B’s historical book and tax basis in the machinery equipment is $20 and zero for both customer lists and goodwill. In this case, Holdco A’s new book and tax basis in the purchased machinery and equipment is $70, $10 for the customer lists and $20 for the goodwill. Tax depreciation and amortization would be calculated on these values and their respective lives going forward (presumably 7-year MACRS for the machinery and equipment and 15 years for both customer lists and goodwill).
On the other hand, if Holdco A purchases the stock of Company B, Holdco A does not receive a step-up to FMV in the underlying assets acquired for tax purposes as it does for GAAP purposes and instead receives carryover tax basis. Using the same example mentioned above, the purchaser would receive carryover tax basis in the machinery and equipment acquired of $20 ($70 for GAAP purposes) and carryover tax basis in the customer lists and goodwill which are both zero ($10 and $20, respectively, for GAAP purposes). Depreciation would continue for tax purposes on the machinery and equipment as if the transaction never happened. Another difference, and a potential benefit, is that tax attributes of the acquired company in a stock deal generally carryover to the purchaser, such as net operating losses (NOLs), alternative minimum tax (AMT) credits, etc. (Also, don't forget to consider Section 382.)
From an income tax accounting standpoint, the purchase accounting mechanics in an asset deal are generally straightforward and easier to incorporate than a stock deal. Opening deferred tax assets / liabilities need to be recorded to the extent of any book and tax basis differences in the asset / liabilities acquired. As you can see in the example above, there would generally be no opening deferred tax assets or liabilities to record if the deal was an asset purchase, since both book and tax basis will have the same basis in the assets acquired. This is not the case if the deal was a purchase of Company B’s stock. As previously mentioned, books would record a step-up and tax would receive carryover treatment. These basis differences create a need for the establishment of opening deferred tax assets or liabilities. We explore this example, specific to a stock deal, in more detail below:
You might be wondering why the difference between book and tax basis in goodwill is not included as part of the opening DTL. ASC 805-740-25-8 requires separation of goodwill into two components, Component 1 and Component 2 goodwill. Component 1 goodwill equals the lesser of goodwill for financial reporting purposes or tax-deductible goodwill. Component 2 goodwill is the remainder, if any, of goodwill for financial reporting purposes in excess of tax-deductible goodwill or the remainder, if any, of tax-deductible goodwill in excess of goodwill for financial reporting purposes. Generally, if tax-deductible goodwill is greater than book goodwill, a deferred tax asset (DTA) is recognized. However, no DTL is recognized if the inverse is true, which is our fact pattern above and the reason why no DTL is recorded for the goodwill basis difference.
It is also important to note that to the extent book and tax basis of the assets were not the same at the time of the acquisition, there would most likely already be deferreds established for such basis differences. In that case, the opening deferred established through purchase accounting would be computed based on the difference between FMV of a particular asset and the net book value at the time of the closing balance sheet date (which should be the same as the step-up the purchaser would record). Lastly, DTAs should be recorded for tax attributes that carryover to the purchaser.
2. Hybrid Transactions
Understand Section 1? Let’s throw in a wrinkle. Some transactions can be a combination of stock and assets. Transactions can also be structured to be part stock, part asset, in which carryover principles partly apply and a step-up is applied to some. For example, a company could acquire 100 percent of the stock of a C corporation and 100 percent of the membership interests of a partnership that is owned by the same individuals of the corporation. Assume the sale of both entities is all encompassed as part of one transaction with one purchase price. The 100 percent purchase of the membership interests of the partnership in this case would be similar to a Revenue Ruling 99-6 transaction, situation 2, whereby this would be a deemed asset purchase for tax purposes. Problems can arise if the purchase price, and associated values, is not bifurcated between the two acquired entities since each yield different tax treatment. As discussed above, an IRC Section 338 election can be made to treat the purchase as a purchase of assets from a tax perspective.
3. Contingent Consideration – Escrow and Earn-outs
Many transactions include some form of contingent consideration such as escrows and earn-outs. Escrow accounts are established and funds set aside as part of a transaction and key to a negotiated deal. Meanwhile, earn-outs are a common feature often negotiated to allow the buyer and seller to bridge the valuation gap. Both are often neglected or mistreated when it comes to tax accounting. Below are the purchase accounting / tax provision takeaways when dealing with escrows and earn-outs:
- Generally no opening DTA/DTL is recorded for purchase accounting in either an asset or stock deal.
- In an asset deal, tax basis in goodwill is not created until the amounts in escrow are released / paid. An analysis of Components 1 and 2 goodwill would need to be performed, but in the case of an asset acquisition, book goodwill is generally equal to tax goodwill (you would include the portion of goodwill that relates to the escrow in this comparison).
- In a stock deal, the release/payment of amounts in escrow generally does not create tax basis in goodwill.
- Generally treated the same as escrow arrangements. However, earn-outs are often re-measured to FMV at each subsequent balance sheet date for book purposes. These subsequent revaluations, either up or down, run through earnings and create either a DTA in the case of an increase in valuation or a DTL in the case of a decrease in the valuation. Upon settlement of the earn-out, tax basis in goodwill would be created and amortization would begin. Any DTA / DTL created because of revaluations would reverse upon sale of the company / goodwill.
4. Transaction Costs
To deduct or capitalize, that is the question (for more information on transaction costs, see Transaction Cost Analyses: What You Should Know). In a stock deal, transaction costs are generally of more concern than in an asset deal, since certain transaction costs may be capitalized and thus attach to the stock basis of the company acquired. As a result, many such costs are essentially permanent in nature and thus impact the purchaser’s effective tax rate (ETR) and total tax provision. On the other hand, in an asset deal, certain capitalized transaction costs may be amortized over a period of time (generally 15 years) and thus are temporary differences that would not affect the taxpayer’s ETR. As is the case with many tax departments, timing is tight to turn around the tax provision, and in the absence of a formal transaction cost study, knowledge of the tax treatment of the buyer’s transaction costs is something you should have in your back pocket.
5. Indefinite-Lived Intangible Assets
It’s not often tax accountants get to use the word “naked” in their line of work. However, in tax accounting we have the concept of dangling DTLs, or “naked credits” as they are commonly referred to. A naked credit is a DTL that has an indefinite useful life and in many cases cannot be used as a source of taxable income to support the realization of deferred tax assets. Some examples of items that might create a naked credit would be goodwill or indefinite-lived intangibles that will not reverse until some indefinite future period when the asset is either sold or impaired. A valuation allowance may be necessary to the extent there are no other sources of taxable income even though an entity might be in an overall net DTL position.
Other Quick Hitters:
6. Jurisdictional Presence
An acquisition of a new company could mean new tax return filings. An understanding of each state’s taxing regime, separate versus combined state filing requirements, and blended state rate considerations (such as weighting methodologies, etc.) are items that should be considered not only for tax purposes going forward but also for tax accounting purposes.
7. Deferred Revenue:
Did your company’s acquisition of assets and liabilities from another company include deferred revenue? For more information, see A Riddle, Wrapped in a Mystery, Inside an Enigma – The Treatment of Deferred Revenue in an Asset Acquisition.
8. Form 8594, Page 2
Upon settlement of contingent consideration (i.e., escrow, earn-outs, etc., discussed above), page 2, part III, of Form 8594 may need to be completed to capture the increase or decrease in consideration.
9. Accounting Method Change
Consider if the acquired entity is using tax accounting methods that might need to be changed (e.g., was the acquired entity able to use the cash method of accounting but unable to going forward as a result of the acquisition?).
10. ASU 2014-02, Private Company Goodwill
Private companies may elect to amortize book goodwill over a 10-year period, straight line, under Accounting Standards Update 2014-02, Intangibles — Goodwill and Other (Topic 350). Depending on the original tax treatment of this goodwill during purchase accounting, the book amortization could be treated as either a permanent difference or temporary difference.
Alvarez & Marsal Taxand Says:
Gone are the “back-of-the-envelope” income tax provision days, and the many nuances of business combinations and purchase accounting may make you long for such days. Gaining a full understanding of a transaction’s structure and corresponding tax treatment is critical to understanding the tax accounting consequences in a business combinations setting and avoiding misapplying the complex rules of purchase accounting and potentially a restatement. Not only is tax accounting expertise key to appropriately accounting for all of the components of a transaction, but open communication between the parties involved in the transaction and those knowledgeable about its specific book and tax treatment is critical and something that, if done correctly, may warrant a thank-you note.
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.
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