How ASC 740 Applies to Business Combinations
April 7, 2022
ASC 740 governs how companies recognize the effects of income taxes on their financial statements under U.S. GAAP.
Business combinations can give rise to a variety of complicated issues when accounting for income taxes under ASC 740, as the acquirer must account for the potential tax effects of carryforwards and income tax uncertainties. However, the market’s most powerful tax provision software provides practitioners an accurate calculation, intuitive design, and thorough footnotes.
What is a 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.”
Generally, the acquiring company recognizes any assets acquired, liabilities assumed, and noncontrolling interests at fair value in a business combination. Goodwill is generally the total value of the acquisition over and above the fair value of identifiable net assets (including deferred tax accounts and intangibles). Determining the initial opening balance sheet of the acquired business is known as purchase accounting.
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. These changes can be recorded to goodwill during the measurement period, which begins on the acquisition date and ends on the earlier of:
- The date in which all information, facts and circumstances as of the acquisition date are known, or
- The one-year anniversary of the acquisition date.
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When is a business combination taxable?
ASC 805 uses the terms “taxable” and “nontaxable” business combinations. These terms refer to whether a tax is imposed on the acquired entity as a result of a business combination. This should not be confused with the terminology regarding tax-free reorganizations under U.S. tax law.
Taxable Business Acquisitions
Taxable business combinations typically involve acquiring the net assets of the acquired entity rather than its stock. 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.
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.
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.
Other Deferred Tax Consequences
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.
Non-Taxable 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 subsequent to 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 post-acquisition 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.
How do deferred tax assets and liabilities impact goodwill in a business combination?
Goodwill is the residual value of the acquired net assets, including deferred tax assets (DTAs) and deferred tax liabilities (DTLs). Consequently, goodwill can only be calculated 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 (VAs). A company must evaluate the need for a VA against its acquired deferred tax assets as of the acquisition date. A VA recorded as part of purchase accounting will increase the amount of goodwill recognized for GAAP purposes on the acquisition date. Conversely, if a business combination causes a change in judgment with respect to 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.
Though tax-deductible goodwill only arises 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/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.
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Examples of the interaction between business combinations and ASC 740
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How do business combination transaction costs affect the ASC 740 tax provision?
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 consideration paid.
Only certain transaction costs related to a business combination may be deductible for tax 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.
Watch an excerpt (8:44) from our webinar that covers the treatment of transaction costs.
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