Business Combination Tax Treatment Under ASC 740

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What is an ASC 805 business combination?

ASC 805 defines a business combination as “a transaction or other event in which an acquiring entity obtains control of one or more businesses.”

Business combinations can give rise to a variety of complicated tax implications when calculating the provision for income tax under ASC 740, which governs how companies recognize the effects of income taxes on their financial statements under U.S. GAAP. When a company acquires the assets of another entity, it must account for the potential tax effects of tax credit carryforwards and income tax uncertainties.

Taxable vs. nontaxable business combinations

ASC 805 distinguishes between “taxable” and “nontaxable” business combinations. These terms refer to whether a tax is imposed on the acquired entity because of a business combination. This should not be confused with the terminology regarding tax-free reorganizations under U.S. tax law.

Taxable income from asset acquisitions

Taxable business combinations typically involve acquiring the net assets of the acquired entity rather than its stock. The tax attributes of the acquiree, such as net operating losses (NOLs) and tax credit carryovers, do not transfer to the acquirer in an asset acquisition.

A taxable asset acquisition may create tax-deductible goodwill equal to the excess of the purchase price over the fair value of the net assets. Goodwill is generally the total value of the acquisition over and above the fair value of identifiable net assets, including deferred tax accounts and intangible assets.

Though the acquired net assets are recorded at fair value for both GAAP and tax purposes, there are often differences in determining the fair value or allocating value between the acquired assets and liabilities under the two systems. Deferred taxes are recorded for the differences between the book basis and tax basis of the acquired assets and liabilities.

A business combination may have other deferred tax consequences due to the expected impact of the acquired business on federal, state, and foreign tax filings. These income tax impacts are recorded to continuing operations rather than through purchase accounting.

Nontaxable stock acquisitions

Generally, in a nontaxable business combination, the acquirer purchases the acquiree’s stock. Under U.S. tax law, the acquirer has carryover tax basis in the acquired company’s assets after a stock acquisition of a corporate entity. Unlike an asset purchase, a stock acquisition does not create tax-deductible goodwill.

Tax attributes such as NOLs and tax credit carryovers are typically retained after a change in ownership in a stock acquisition. The company should record the appropriate deferred taxes for those attributes. However, §382 and §383 may limit an acquirer’s ability to utilize pre-acquisition date tax attributes to offset postacquisition taxable income. In that case, it may be appropriate to record a valuation allowance based on the facts and circumstances.

The financial reporting basis in the net assets is reported at fair value, whereas the tax basis is carryover basis. Therefore, deferred taxes should be recorded on differences between the book and tax basis of the net assets in the acquired company.

A taxpayer may elect to treat a stock acquisition as an asset acquisition for U.S. tax purposes. If a company makes such an election, its purchase accounting and related deferred taxes should reflect the fair value tax basis based on that election and be accounted for as a taxable business combination.

Asset acquisition method of accounting for business combinations

Generally, in business combinations the acquiring company recognizes the fair value of any:

• Assets acquired
• Liabilities assumed
• Noncontrolling interest

Determining the initial opening balance sheet of the acquired business is known as purchase accounting.

Purchase accounting and balance sheet adjustments

Companies may record retrospective adjustments to the opening balance sheet during a measurement period if they become aware of new facts and circumstances that existed on the acquisition date. The measurement period begins on the acquisition date and ends on the earlier of either:

• The date when all information, facts, and circumstances as of the acquisition date are known
• The one-year anniversary of the acquisition date

During the measurement period of up to one year, these purchase accounting revisions can be recorded to goodwill.

Acquisition cost accounting treatment

For GAAP purposes, transaction costs such as professional, legal, and accounting fees are expensed as period costs rather than capitalized as a part of the purchase consideration paid.

Only certain transaction costs related to a business combination may be deductible for ASC 740 income tax provision purposes. However, the acquirer often incurs these transaction costs in advance of the acquisition date, and the ultimate deductibility usually cannot be determined until the transaction is consummated.

Due to diversity in practice, the company should consult with its auditor on the appropriate tax accounting treatment of transaction costs when it begins to incur them

Video: Business combination transaction cost tax treatment

This webinar excerpt covers the tax treatment of transaction costs for business combinations. Register to watch the full on-demand webinar for an overview of the income tax provision impacts of business combinations.

Do you calculate deferred tax on goodwill?

Goodwill is the residual value of the acquired net assets, including deferred tax assets and deferred tax liabilities. Consequently, goodwill can be calculated only after consideration of:

• Uncertain tax positions. A company must record any acquired uncertain tax positions and evaluate the measurement of acquired positions that meet the recognition threshold as of the acquisition date.
• Valuation allowances. A company must evaluate the need for a valuation allowance against its acquired deferred tax assets as of the acquisition date. A valuation allowance recorded as part of purchase accounting will increase the amount of goodwill recognized for GAAP purposes on the acquisition date. Conversely, if a business changes the need for a valuation allowance against the acquirer’s deferred tax assets, any increase or decrease to the allowance is recorded in income tax expense from continuing operations.

Can goodwill be written off for tax purposes?

Though tax-deductible goodwill arises only from asset acquisitions (deemed or otherwise), there are often situations in which tax-deductible goodwill may exist within the acquired company from a prior purchase that continues to be deductible after a subsequent stock acquisition or other nontaxable business combination. Since goodwill represents a residual value, ASC 805 does not distinguish the period in which the tax-deductible goodwill originated when determining the components of goodwill.

Components of goodwill

There are two components of goodwill to consider when determining whether to recognize deferred tax assets and liabilities from a business combination.

Goodwill component 1

For GAAP purposes, component 1 goodwill is the lesser of goodwill. For tax purposes, component 1 goodwill is the deductible goodwill. For both, no deferred taxes are recognized at the acquisition date. Any subsequent difference is a temporary difference that creates a deferred tax asset or liability.

Goodwill component 2

Component 2 GAAP goodwill equals the excess of GAAP goodwill over tax-deductible goodwill. No deferred taxes are recognized for GAAP goodwill at the acquisition date or in future years.

Component 2 tax deductible goodwill equals the excess of tax-deductible goodwill over GAAP goodwill. A deferred tax asset is recorded as of the acquisition date, and any subsequent difference is a temporary difference that creates a deferred tax asset or liability.