With merger and acquisition (M&A) activity on the rise in 2024, a trend that practitioners are encountering is the preparation or audit of the associated purchase accounting, which is required under Accounting Standards Codification (ASC) 805, Business Combinations. Many professionals who deal with ASC 805 are well versed in the non-tax aspects, but when tax comes into the picture, many can be outside their comfort zone. The following framework can help ensure that the appropriate considerations are made.
Determine the Tax Structure of the Transaction
The initial consideration that should be made is to understand the tax structure of the acquirer and the acquiree as well as the method being undertaken to effectuate the transaction. This can be done through a careful review of company organizational charts as well as the purchase agreement.
Transactions are effectuated in one of two ways: through a taxable transaction or through a non-taxable transaction.
A taxable transaction leads to a “step-up” in the target’s tax basis of assets acquired and liabilities assumed to fair market value. This type of treatment is typically seen in acquisitions of assets and stock acquisitions that are treated as asset acquisitions for tax purposes by election (e.g., §338 elections for qualified stock purchases).
Conversely, a nontaxable transaction results in a “carryover” of the historical tax basis in the assets acquired and liabilities assumed. Assuming a premium is paid, this will typically result in a lower tax basis than the fair market value utilized for financial statement purposes under ASC 805. This type of transaction generally occurs in an acquisition of the acquired entity’s stock (unless a §338 election is made).
Determine the Financial Statement and Tax Bases
Under ASC 805-20-30-1, the acquirer measures the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree at their acquisition-date fair values. A valuation specialist is typically engaged to assist with the identification and measurement of such fair values. This will typically result in a step-up for financial reporting purposes to the acquired assets and liabilities of the target. The deferred tax consequences of such a step-up will depend on how the transaction is being accounted for from a tax perspective.
Taxable Transactions
In a taxable transaction, the acquirer will receive stepped-up basis in acquired assets and liabilities for both financial reporting and tax purposes. In many cases, the basis in each class of assets will be equal for both financial reporting and tax purposes. Accordingly, no deferred taxes are recorded as part of purchase accounting in these instances. However, in some cases, there can still be a difference between the financial reporting fair value and the tax allocation of acquired assets and liabilities under IRC §1060. When this occurs, deferred taxes are recorded in purchase accounting to reflect the differences between financial reporting and tax bases. It is important to review the purchase agreement in detail as it may outline how the parties will allocate the fair value for tax purposes and can save considerable time during the financial statement preparation and audit.
Non-Taxable Transactions
In a non-taxable transaction, the financial reporting basis of assets and liabilities both receive a step up to fair market value; however, the tax basis in assets and liabilities maintain carryover basis. This will lead to basis differences between book and tax that will require the establishment of deferred tax assets (DTAs) and deferred tax liabilities (DTLs). The most common and significant difference relates to the step-up in non-goodwill intangibles, resulting in a DTL.
A complexity that is commonly faced is accounting for goodwill. In cases where goodwill established for financial reporting purposes exceeds tax-deductible goodwill, no DTL should be established. However, a DTA is established when tax goodwill basis is greater.
Analyze Acquired Tax Attributes
In a non-taxable transaction, tax attributes such as net operating losses, tax credit and disallowed interest expense carry forward to the acquirer. These future tax benefits will be reflected as acquired DTAs which may be significant. However, it is crucial to understand any potential limitations in the future utilization of these acquired tax attributes (e.g., IRC §382 on net operating losses). If an attribute will necessarily expire unutilized due to these limitations, then it is not appropriate to record a DTA as of the date of acquisition.
Perform Realization Assessment for Deferred Tax Assets
Acquirers should assess the need for a valuation allowance against acquired DTAs as part of business combination accounting. An analysis of whether reversing taxable temporary differences (such as DTLs) are sufficient to utilize existing DTAs is an objective way to determine if a valuation allowance is needed, although there are other sources of evidence allowable to be used under the accounting standards (e.g., historical and projected profitability from operations). Also, acquirers should consider if the business combination warrants a change in the valuation allowance assertion for its own DTAs based on the combined entity’s tax position.
Consider Treatment of Tax Uncertainties and Indemnifications
Additional historical tax exposures may be uncovered during the due diligence process. It is imperative that if there are findings on historical positions that the risk be assessed and, if appropriate, recorded as a liability as part of purchase accounting. The recognition and measurement criteria for these findings can vary depending on if the liability falls within ASC 740, Income Taxes, or ASC 450, Contingencies.
Although accounting for the income tax in a business combination is complex, the above framework can be a great starting point to navigate the reporting nuances and considerations.