How ASC 740 Applies to Business Combinations

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.

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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.

Learn more: How to calculate the ASC 740 tax provision

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