Tax effects of a business combination achieved in stages .1 Outside-basis differences .1 Outside-basis differences

An acquirer may obtain control of an acquiree through a series of acquisitions. Such a transaction is commonly referred to as a “step acquisition” transaction and in ASC 805 as a “business combination achieved in stages.” If an acquirer owns a noncontrolling equity investment in an acquiree immediately before obtaining control, the acquirer should, under ASC 805, remeasure that prior investment to fair value as of the acquisition date and recognize any remeasurement gains or losses in earnings.

Additionally, if before obtaining control through a step acquisition, an acquirer recognized changes in the value of a noncontrolling investment in the acquisition target in other comprehensive income (i.e., the investment was classified as available-for-sale in accordance with ASC 320), the amount recognized in other comprehensive income as of the acquisition date should be reclassified out of other comprehensive income and included in the recognized remeasurement gain or loss as of the acquisition date.

The remeasurement of an equity investment to fair value is required because the FASB concluded that a change from holding a noncontrolling equity investment in an entity to controlling that entity is a significant change in the nature of and economic circumstances surrounding that investment. The acquirer exchanges its status as an owner of an investment in an entity for a controlling financial interest in all of the underlying assets and liabilities of that entity and the right to direct how the acquiree and its management use those assets in conducting its operations. In the FASB’s view, that exchange warrants fair value recognition of all net assets over which control has been obtained, and requires

remeasurement through earnings of any previously held noncontrolling interest.

The remeasurement of an equity method investment to fair value will generally result in an increase or decrease in the financial reporting basis of the investment without a corresponding adjustment to the tax basis. The difference between the financial reporting basis and the tax basis of an investment is

commonly referred to as an outside-basis difference and deferred taxes are reported for outside-basis differences related to non-controlling equity investments. The deferred tax consequence of a change in outside-basis difference due to the remeasurement of an equity method investment should be reflected in the acquirer’s income statement outside of acquisition accounting, consistent with the pre-tax treatment discussed above.

Likewise, if the remeasurement were to trigger a current tax consequence, the current tax effect would be reflected in the acquirer’s income statement. This accounting treatment will result in the same aggregate accounting, although in different periods, regardless of whether an investment is accounted for under the equity method or at fair value (e.g., under the fair value option). Had the equity method investment been accounted for using the fair value option and measured at fair value at each reporting date, the related deferred tax consequences would have been reported in the acquirer’s income statement at each reporting date and there would be no difference to recognize on the date of acquisition.

The following example illustrates these concepts:

Illustration 11-11

Assume that Company X has a 30-percent investment in Company Y accounted for under the equity method. At the beginning of 20X9, Company X acquires the remaining 70 percent of Company Y for

$70. On the date of the acquisition, the financial reporting and tax basis of the 30-percent investment is

$20 and the fair value of the investment is $30. The tax basis in the 70-percent investment is $70 (i.e., there is no outside-basis difference on the 70-percent investment). The tax rate is 40 percent.

Further assume Company X will be required to provide deferred taxes for outside-basis differences subsequent to the acquisition of Company Y (situations in which the acquirer is no longer required to provide deferred taxes for outside-basis differences are discussed below).

On the date of acquisition, Company X would report a $10 gain on the remeasurement of its 30-percent investment in Company Y. Company X would also report deferred tax expense, and a corresponding increase in its deferred tax liability of $4 ($10 x 40 percent).

The following table summarizes the financial reporting (“book”) and tax basis of Company X’s investment in Company Y:

Book Tax DTA (DTL)

30 -percent interest prior to acquisition

of remaining interest $ 20 $ 20 —

Remeasurement of 30-percent

investment to FV on acquisition date 10 — (4)

30 20 (4)

Purchase of remaining 70-percent

interest 70 70 —

Total investment in Company Y $ 100 $ 90 $ (4)

As discussed above, when a business combination is achieved in stages and the initial investment was classified as available-for-sale in accordance with ASC 320, unrealized gains or losses recognized in other comprehensive income as of the acquisition date should be reclassified out of other comprehensive income and recognized in the income statement on the acquisition date. The corresponding deferred tax consequence previously recognized in other comprehensive income related to such unrealized gains or losses would also be removed from other comprehensive income and recognized in the income

statement. For simplicity, this discussion presumes the tax effects originally recognized in other comprehensive income equal those related to the gain recognized in the income statement as realized.

For ASC 320 securities carried at cost, the approach articulated above for equity method investments should be followed (i.e., the deferred tax consequence of a change in outside basis should be recognized in the acquirer’s income statement).

After achieving control of a target company, further acquisitions of ownership interests (i.e., acquisitions of noncontrolling ownership interests) are accounted for as transactions among shareholders pursuant to ASC 810. Accordingly, neither step acquisition nor business combination accounting principles will apply to accounting for such transactions. See Section 12.2, Changes in ownership interest in a subsidiary other than in a business combination, for further detail.

11.16.1.1 Deferred tax liabilities for domestic subsidiaries acquired in stages

In a business combination achieved in stages, an acquirer may not be required to report deferred taxes on outside-basis differences once the acquirer obtains control of the acquiree. ASC 740-30-25-7 requires a company to assess whether the excess of the reported amount of an investment (including undistributed earnings) in a domestic subsidiary for financial reporting purposes over the underlying tax basis is a taxable temporary difference. If the tax law provides a means by which the reported amount of an investment in the stock of a domestic subsidiary could be recovered in a tax-free transaction (e.g., a tax-free liquidation or a statutory merger) and the company expects that it ultimately will use that means to recover its investment, the outside-basis difference would not be considered a taxable temporary difference because no taxes are expected to result when the temporary difference reverses.

We believe that if a deferred tax liability on the outside-basis difference of an investment, including any deferred taxes associated with recognizing the holding gain described above, is no longer needed

because the acquirer has the ability to recover the amount tax free once control is obtained, the deferred tax liability on the outside-basis difference should be reversed in the acquirer’s income statement in the reporting period that includes the business combination. This accounting is consistent with the

accounting for a change in the acquirer’s valuation allowance in accordance with ASC 805-740-30-3. A change in an acquirer’s valuation allowance for a deferred tax asset that results from a change in the acquirer’s circumstances caused by a business combination must be accounted for as an event separate from the business combination. Similar to a change in the acquirer’s valuation allowance, although the deferred taxes on the outside-basis difference are no longer needed because of the business

combination, the deferred tax liability relates to the acquirer’s pre-existing interest, and, therefore, changes in that liability should be accounted for outside of acquisition accounting. See Section 14-6, Investments in domestic subsidiaries, for further discussion and additional considerations.

The following example illustrates these concepts:

Illustration 11-12

Assume that Company X has a 30-percent investment in Company Y accounted for under the equity method. At the beginning of 20X9, Company X acquires the remaining 70 percent of Company Y for

$70. On the date of the acquisition the financial reporting basis of the 30-percent investment is $25, the tax basis is $10, and the fair value is $30. A deferred tax liability of $6 relating to the equity investment exists immediately prior to the acquisition. The tax basis in the 70-percent investment is

$70 (i.e., there is no outside-basis difference in the 70-percent investment). The tax rate is 40 percent. Further, assume the tax law provides a means by which the reported amount of the investment in the stock of Company Y, a domestic subsidiary, could be recovered in a tax-free transaction and Company X expects that it ultimately will use that means to recover its investment.

Because the tax law provides a means by which the reported amount of the investment in the stock of Company Y could be recovered in a tax-free transaction and Company X expects that it ultimately will use that means to recover its investment, Company X’s outside-basis difference in Company Y, including the $2 difference related to the $5 gain on remeasurement of Company X’s original 30-percent investment (($30 fair value — $25 financial reporting basis) x 40 30-percent), would not be considered a taxable temporary difference and no deferred tax liability would be required. Therefore, Company X would report a net deferred tax benefit of $6, which represents the reversal of the deferred taxes related to the original outside-basis difference in the equity method investment (($25 financial reporting basis — $10 tax basis) x 40 percent).

11.16.1.2 Deferred tax liabilities for foreign subsidiaries acquired in stages

ASC 740-30-25-17 provides an exception to comprehensive recognition of deferred taxes for temporary differences related to undistributed earnings of foreign subsidiaries and foreign corporate joint ventures that are, or will be, invested indefinitely. However, when an acquirer holds an equity investment in an acquiree prior to obtaining control, ASC 740-30-25-16 requires that the temporary difference for the acquirer’s share of the undistributed earnings of the acquiree prior to the date it becomes a subsidiary continues to be treated as a temporary difference for which a deferred tax liability must be recognized to the extent dividends from the subsidiary do not exceed the parent company’s share of the subsidiary’s earnings subsequent to the date it became a subsidiary (i.e., a deferred tax liability related to an equity investment must be frozen until the temporary difference reverses).

As discussed above, under ASC 805, if an acquirer owns a noncontrolling equity investment in an acquiree immediately before obtaining control, the acquirer must remeasure that investment to fair value as of the acquisition date and recognize any remeasurement gains or losses in earnings. A question arises whether the deferred tax liability that must be frozen in accordance with ASC 740-30 should include the deferred tax consequences of remeasuring an equity investment to fair value when a foreign subsidiary is acquired in stages. This question arises because although ASC 740-30-25-16 specifies that deferred tax liabilities related to undistributed earnings should be frozen, it does not specify whether the outside-basis difference resulting from remeasuring an acquirer’s investment to fair value should be included in the amount frozen as this difference is not related to undistributed earnings. However, ASC 740-30-25-18 extends the ASC 740-30 exception for recognizing a deferred tax liability for undistributed earnings indefinitely invested to include the entire amount of a temporary difference between the financial reporting and tax basis of an investment in a foreign subsidiary. Therefore, we believe the most appropriate treatment is to freeze the deferred tax liability on the outside-basis difference in the equity investment after the investment has been remeasured to fair value (i.e., the amount frozen should include the deferred tax consequences of the remeasurement of the investment).

As a result, the amount of the deferred tax liability frozen will equal the outside-basis difference of the investment at fair value immediately prior to obtaining control.

The following example illustrates these concepts:

Illustration 11-13

Assume that Company X has a 30-percent investment in Company Y accounted for under the equity method. At the beginning of 20X9, Company X acquires the remaining 70 percent of Company Y for

$70. On the date of the acquisition, the financial reporting basis of the 30-percent investment is $20, the tax basis is $10, and the fair value is $30. The tax basis in the 70-percent investment is $70 (i.e., there is no outside-basis difference in the 70-percent investment). The tax rate is 40 percent.

Further, assume that Company X is able to assert that the earnings of Company Y, a foreign subsidiary, will be indefinitely reinvested.

On the date of acquisition, Company X would recognize a $10 gain on the remeasurement of its 30-percent investment in Company Y. Company X would also recognize deferred tax expense, and a corresponding increase in its deferred tax liability of $4 ($10 x 40 percent). Although, Company X is able to assert that the earnings of Company Y will be indefinitely reinvested, the entire existing deferred tax liability of $8 (($30 adjusted financial reporting basis — $10 tax basis) x 40 percent) would be frozen until the temporary difference reverses.

11.16.1.3 Limitations on deferred tax assets for subsidiaries

ASC 740-30-25-9 restricts recognition of a deferred tax asset for the excess of the tax basis over the financial reporting basis of an investment (outside-basis difference) in either a foreign or domestic subsidiary or corporate joint venture. For those outside-basis differences, a deferred tax asset is recognized “only if it is apparent that the temporary difference will reverse in the foreseeable future.”

This restriction on the recognition of deferred tax assets on outside-basis differences was included to bring some form of consistency with the exceptions provided for deferred tax liabilities, in ASC 740-30-25-7 and ASC 740-30-25-18.

In a business combination achieved in stages, unless the acquirer is able to assert that the outside-basis difference will reverse in the foreseeable future, which is expected to be rare, the acquirer will be required to write-off any deferred tax asset related to an equity investment once the acquirer obtains control. Similar to the treatment of deferred tax liabilities discussed above, although the recognition of a deferred tax asset on the outside-basis difference is no longer permitted because of the business

combination, the deferred tax relates to the acquirer’s pre-existing interest, and, therefore, should be accounted for outside of acquisition accounting (i.e., accounted for in the income statement).

In many cases, the acquirer will have already reported a valuation allowance for a deferred tax asset related to an equity investment, and once control is obtained the acquirer will simply write-off both the deferred tax asset and the related valuation allowance; as a result, there is no current period tax effect from the write-off.

The following example illustrates these concepts:

Illustration 11-14

Assume that Company X has a 30-percent investment in Company Y accounted for under the equity method. At the beginning of 20X9, Company X acquires the remaining 70 percent of Company Y for

$35. On the date of the acquisition the financial reporting basis of the 30-percent investment is $10, the tax basis is $20 and the fair value is $15. The tax basis in the 70-percent investment is $35 (i.e., there is no outside-basis difference in the 70-percent investment). The tax rate is 40 percent. Company X has not reported a valuation allowance against the deferred tax asset for the equity investment. The outside-basis difference in the subsidiary is not expected to reverse in the foreseeable future.

On the date of acquisition, Company X would recognize a $5 gain on the remeasurement of the 30-percent investment. Company X would also recognize tax expense of $2 ($5 x 40 30-percent). Because the outside-basis difference in Company Y is not expected to reverse in the foreseeable future, the net deferred tax asset remaining of $2 (($20 tax basis — $15 adjusted financial reporting value) x 40 percent) should be charged off to expense outside of acquisition accounting in Company X’s current period income statement.

Had Company X reported a valuation allowance against the deferred tax asset, the deferred tax asset remaining of $2 would be written off against the $4 valuation allowance. The remaining $2 valuation allowance would no longer be needed and would be reported as a tax benefit and the overall tax effect of this transaction would be zero ($2 tax expense on remeasurement — $2 tax benefit on elimination of valuation allowance).

11.16.2 Inside-basis differences

In a nontaxable business combination, such as a stock acquisition, the historical tax bases of the assets acquired and liabilities assumed carry over from the acquired company, which results in different

financial reporting and tax bases of the assets acquired and liabilities assumed (referred to as inside-basis difference). However, in certain circumstances, the tax bases in the assets acquired and liabilities

assumed may be stepped up to fair value as a result of negotiation among the buyer and seller, eliminating the inside-basis difference. In a business combination achieved in stages, this election does not apply to the portion of the acquiree owned by the acquirer prior to obtaining control. Therefore, when such an election is made in a business combination achieved in stages, the assets acquired and liabilities assumed will not be stepped up to their full fair value for tax purposes and deferred taxes must be reported on the related inside-basis difference. Had such a business combination been achieved in a single purchase with a 338 election, there would be less of a chance that an inside-basis difference would exist at the date of acquisition.

A question arises whether the deferred tax consequences of an inside-basis difference resulting from a previously held investment in an acquiree should be reflected in the acquirer’s income statement outside of acquisition accounting or included in acquisition accounting, which will generally result in an increase in goodwill. ASC 805-740-25-2 requires that an acquirer recognize and measure deferred taxes arising from assets acquired and liabilities assumed, and the potential tax effects of temporary differences, carryforwards, and any income tax uncertaintiesof the acquiree that exist at the acquisition date or arise as a result of the acquisition in accordance with ASC 740. As noted previously, the FASB believes that a change from holding a noncontrolling equity investment in an entity to obtaining control of that entity is a significant change in the nature of and economic circumstances surrounding that investment. The acquirer exchanges its status as an owner of an investment in an entity for a controlling financial interest in all of the underlying assets and liabilities of that entity. Because the assets and liabilities that create the inside-basis differences are not acquired and recognized until the acquirer obtains control of the acquiree, we believe that any deferred taxes arising from inside-basis differences of assets acquired and liabilities assumed should be recognized in acquisition accounting (i.e., the deferred tax consequences of the assets acquired and liabilities assumed should be recognized in the same manner as the assets and liabilities themselves — in acquisition accounting).