Mergers & acquisitions a snapshot Changing the way you think about tomorrow s deals

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1 Mergers & acquisitions a snapshot Changing the way you think about tomorrow s deals Stay ahead of the accounting and reporting standards for M&A 1 June 10, 2015 What's inside Bankruptcy period considerations... 2 Fresh start considerations... 2 In summary... 4 Companies in distress: Tax planning and accounting considerations Navigating a reorganization process while continuing to operate a business can prove challenging and time consuming. Among other things, management must evaluate turnaround alternatives, analyze claims, develop reorganization plans, attend court proceedings, and prepare financial reporting information. With these competing demands on management s time, it s important that income tax considerations not be ignored. Income taxes can influence a decision to file for bankruptcy, as there are income tax benefits that are only available in bankruptcy, and can directly impact the entity s financial results and post-reorganization liquidity. This edition of Mergers & acquisitions a snapshot, is the fourth in a series focused on companies in distress. This snapshot highlights important tax planning and accounting considerations for companies in the Chapter 11 bankruptcy process. 1 Accounting Standards Codification 805 is the U.S. standard on business combinations, Accounting Standards Codification 810 is the U.S. standard on consolidation (collectively, the M&A Standards ), and Accounting Standards Codification 852 is the U.S. standard on reorganizations (the Reorganization Standard ). M&A snapshot 1

2 Bankruptcy period considerations A bankruptcy filing by the parent of a U.S. consolidated tax return group does not result in the termination of the tax group, nor does it release the group from its tax reporting obligations. The debtor parent must continue to file a consolidated return with its subsidiaries. Similarly, if a subsidiary in a consolidated tax return group files for bankruptcy, it nonetheless remains a member of the group. A bankruptcy filing can result in book/tax reporting differences. For example, a company may cease accruing interest on debt for book purposes, but the contractual interest may continue to be deductible for tax purposes. Leases and other contractual arrangements may be cancelled in connection with the bankruptcy negotiations, while provisions related to contract or lease terminations are typically not tax deductible until settled. Professional fees and other expenses related to the bankruptcy process that are expensed for book purposes may be permanently nondeductible for tax purposes. Companies in distress often need to recognize a valuation allowance against deferred tax assets. A valuation allowance is required when there is insufficient evidence supporting the future profitability needed to benefit from the assets. Without a valuation allowance, book/tax timing differences would not impact the effective tax rate. When there is a valuation allowance, however, temporary differences can impact an entity s effective tax rate. Changing expectations Deferred tax assets and liabilities are recognized and measured based upon expectations relating to their future recovery or settlement. Changes in relevant expectations, both pre- and post-bankruptcy filing, must therefore be monitored closely. In addition to possible changes in valuation allowances, bankruptcy can trigger other significant changes in expectations, such as those related to investments in subsidiaries and the apportionment of taxable income among states. If a company expects to dispose of a subsidiary, or remit foreign earnings, a tax expense or benefit may be triggered. Changes in expectations relating to the future state tax rate can result from contract or lease terminations, disposals, relocations or other business events which will alter the company s geographic footprint. This can require a remeasurement of state deferred taxes, resulting in a tax expense or benefit. Sales of assets Sales of the debtor s assets can occur through a courtapproved auction or as part of the debtor s reorganization plan and often will result in the ability to transfer assets free and clear of most liens and claims. Two approaches are typically considered for tax purposes in bankruptcy proceedings. A tax-free reorganization may be possible if most of the business is being transferred to creditors at emergence pursuant to a court-approved plan of reorganization. Alternatively, certain appreciated assets may be transferred to creditors in satisfaction of their debts. In these instances, the debtor's tax losses are used to offset the taxable income from the asset disposals, and the creditors will obtain a fair value (step-up) in the tax basis of the assets. In addition, the debtor obtains cash or other property from the sale, which can then be used to settle debts with creditors. This approach can result in the deferral or elimination of taxable income resulting from the favorable treatment of debt cancellation income in bankruptcy, discussed further below. Fresh start considerations An emergence from bankruptcy and the application of fresh start reporting 2 has no impact on the tax bases of the entity s assets and liabilities. However, the emergence typically will involve transactions that have tax consequences (e.g., debt cancellation and/or ownership changes that may limit the subsequent use of tax attributes). In fresh start reporting, balance sheet items for book purposes are adjusted to their fair values to reflect a new entity basis. Deferred taxes are generally recorded for the difference between the fair value and the tax bases of the assets and liabilities in a manner similar to acquisition accounting (income tax assets and liabilities are not recorded at fair value). If book goodwill recorded through the allocation of reorganization value exceeds taxdeductible goodwill, no deferred tax liability would be recorded. In the unusual circumstance that tax-deductible goodwill exceeds book goodwill, a deferred tax asset would be recorded for the difference. A valuation allowance is recorded against deferred tax assets if it is more likely than not that the tax benefits will not be realized. In determining whether a valuation 2 See April 30, 2015 Mergers & acquisitions a snapshot, Companies in distress Emerging from bankruptcy M&A snapshot 2

3 allowance should be recorded, past results of the company should not be ignored. However, the analysis should focus principally on the post-reorganization outlook of the company. Changes in ownership tax attribute limitation The reorganization plan may create changes in the debtor's stock ownership, whether through an issuance of stock to creditors or to new investors. Under the U.S. federal tax laws, certain changes in ownership can cause an annual limitation on the future use of a company's unrealized loss and tax attribute carryforwards. The limitation can restrict the timing of tax attribute utilization, and possibly cause tax attributes to eventually expire unused. However, special tax rules are available for companies in bankruptcy that may lessen the impact of a change of ownership on a company's tax attributes. An annual limitation on utilizing tax attributes may trigger the need for a valuation allowance against deferred tax assets as part of fresh start reporting. Assessing whether and how much of a valuation allowance is needed may require detailed scheduling of the reversal pattern of existing temporary differences. In cases where the limitation will mathematically preclude the use of a portion of the tax attribute, it generally is appropriate to derecognize the gross deferred tax asset as opposed to recording a valuation allowance, since it will never provide a tax deduction or benefit. Cancellation of share-based awards In most bankruptcy proceedings, the pre-bankruptcy sharebased compensation awards are worthless and are cancelled, along with the entity s outstanding shares, at emergence under the plan of reorganization. If nonqualified stock options are cancelled, the company would record any remaining unrecognized compensation expense related to the cancelled award, and a related deferred tax asset, which may need to be accompanied by an increase in the valuation allowance. The company would then account for the resulting "shortfall" from cancelling the awards. A shortfall results because the tax deduction (zero) is less than the book compensation expense. The deferred tax asset write-off (net of any valuation allowance) is first charged to equity to the extent of the company's windfall pool and then to the income statement. For companies adopting fresh-start reporting for book purposes, there would be no pool of windfall tax benefits on the date of emergence. Debt restructuring Debt restructuring transactions may involve cash settlement, an issuance of equity for debt, an exchange of debt, or modification of debt terms. Debt cancellation income that arises in a bankruptcy is often afforded more favorable tax treatment than debt cancellation income that arises outside of a bankruptcy. For debtors in bankruptcy, there is no limitation on the amount of debt cancellation income that is eligible for deferral or elimination. Generally, the deferral of income occurs via a reduction of the debtor's tax bases in assets and/or other tax attributes, such as loss or credit carryforwards. Elimination of income occurs to the extent the debt cancellation income exceeds the available bases and attributes. This eliminated amount is commonly known as black hole income. The following example illustrates the treatment of debt cancellation income for a bankrupt company. Example Debt cancellation income A company has debt cancellation income of $120 but only $90 of tax bases in assets and other attributes. The table below illustrates the deferral and elimination of debt cancellation income by a company that is in bankruptcy. Debt cancellation income $120 Debt cancellation income excluded from gross income Reduction of bases in assets and other tax attributes Permanent elimination of debt cancellation income (120) (90) The bases and/or attribute reduction is made at the beginning of the next tax year (i.e., the year after the year in which the debt restructuring occurs). Accordingly, it only affects tax bases in assets or attributes that exist at the beginning of that year. The reduction is subject to specific ordering rules and can include the basis of stock of a subsidiary. Companies can make an election to change the order to reduce the basis of property first. If the basis in the stock of a subsidiary is reduced and the debtor and subsidiary are members of a U.S. consolidated tax return group, then the subsidiary must reduce the bases of its assets and/or tax attributes. Special rules can also 30 M&A snapshot 3

4 require a reduction in the tax attributes of other members of a consolidated return group. Black hole income may result in the recognition of a tax liability to the extent it triggers an excess loss account. An excess loss account relates to a parent company s tax basis in its investment in a subsidiary which may not have previously resulted in a deferred tax liability on the basis that the tax law provided a means through which the tax could be avoided. Impact on deferred taxes The appropriate accounting for debt cancellation income upon emergence will depend on the facts and circumstances. Deferred taxes generally will be recorded for the effects of a tax deferral that causes a reduction in the tax bases of assets. Similarly, a reduction of tax attributes would result in a write-off of any related deferred tax assets. If a valuation allowance was previously recorded against the deferred tax assets, it would also be released, thereby offsetting the income and balance sheet effects. One possible approach is for the company to project taxable income (and other changes in tax bases/attributes) between emergence and the beginning of the next tax year and record deferred taxes based on the attributes and tax bases expected to exist at the beginning of the next tax year. An alternative method is for the company to record deferred taxes without adjusting for the changes in tax attributes and tax bases expected to occur by the beginning of the next tax year. This alternative may be appropriate, for example, if the projections of asset and attribute activity are subject to significant variability. No matter which alternative is used, the true-up of the deferred tax amount at the end of the tax year would generally be recorded in the financial statements of the successor entity to the extent it represents a change in estimate. If debt cancellation income is deferred by decreasing the tax basis of the debtor's investment in the stock of a subsidiary, the income tax accounting effects may vary depending on whether the debtor and the subsidiary file a U.S. consolidated tax return. If stock of a consolidated tax return subsidiary is reduced, that subsidiary s tax bases in assets and/or attributes are reduced. A deferred tax liability is often not recorded on the basis difference for an investment in a domestic subsidiary because there is often a way of recovering the investment in a tax-free manner (e.g., a taxfree merger or liquidation). However, a reduction of the subsidiary s stock basis in excess of its tax attributes can make a tax-free liquidation impossible, thereby requiring a deferred tax liability. If the subsidiary is not a member of the consolidated tax return group, there would be no reduction in the tax bases of the subsidiary's assets and/or attributes. The deferred tax impact of a change in the tax basis of an investment in a foreign subsidiary depends on whether the parent is making an indefinite reinvestment assertion. That is, if the parent expects the basis difference to remain indefinitely, a deferred tax liability is not recorded. In that circumstance the change in tax basis will not impact deferred taxes. If the indefinite reinvestment assertion cannot be sustained, the change in tax basis generally would result in a deferred tax liability. Subsequent changes In addition to the true-up of deferred taxes related to debt cancellation income, there are often other changes in expectations and estimates impacting income tax accounting following a bankruptcy. These are recorded in earnings, rather than as an adjustment to goodwill. These may include: Release of a valuation allowance Changes in uncertain tax positions Changes in expectations related to subsidiary disposals or the indefinite reinvestment of foreign earnings The effective tax rate may, as a result, be more volatile in periods following an emergence from bankruptcy. In summary This is the last edition in our series focused on relevant considerations prior to, during, and after a bankruptcy. Bankruptcies present unique income tax planning and accounting considerations. Effective management of these issues is best accomplished through close coordination among those responsible for the reorganization plan, the valuation process, financial reporting, and income tax considerations. The issues are multidisciplinary, often necessitating additional coordination with outside professionals, such as attorneys, accounting, tax, and valuation experts. While the process may be challenging, a chapter 11 bankruptcy filing can be a valuable opportunity for a company to start fresh and reorganize in a way that is more economically feasible for future periods. Companies that are in distress will want to consider working with their advisors early on to successfully navigate the turnaround process. M&A snapshot 4

5 For more information on this publication, please contact any of the following individuals: Mitch Aeder Deals Principal Bankruptcy Tax Leader (646) Steve Lilley Deals Partner Capital Markets and Accounting Advisory Services (214) Principal Authors: Lawrence N. Dodyk Partner U.S. Business Combinations Leader (973) Edward Abahoonie Partner National Professional Services Group (973) Sara DeSmith Partner National Professional Services Group (973) Christopher Pisciotta Senior Manager National Professional Services Group (973) M&A snapshot 5

6 PwC has developed the following additional M&A Snapshots related to business combinations and noncontrolling interests, covering topics relevant to a broad range of constituents. How timing your transactions in light of the new standards will impact your business and communication with stakeholders Goodwill impairment testing: What's old is new again Deal or no deal: Why you should care about the new M&A standards Even your tax rate will change Accounting for partial acquisitions and disposals it's not so simple! Doing a deal? Be careful about employee compensation decisions Acquired assets not intended to be used: You may need to record them, even if you don't use them! Accounting for contingent consideration Don't let earnouts lead to earnings surprises The Consolidation Standard determining who consolidates is just the beginning Carve-out Financial Statements A challenging process Noncontrolling interests why minority shareholder rights matter Market participants: how their views impact your values Did I buy a group of assets or a business? Why should I care? Don't let push-down accounting push you around Financial risk management considerations in an acquisition We re in the process of acquiring a company with significant in-process research and development (IPR&D) activities. What's next? Cross-border acquisitions Due diligence and preacquisition risk considerations Cross-border acquisitions Navigating SEC reporting requirements Cross-border acquisitions Accounting considerations relating to income taxes Cross-border acquisitions Post-acquisition considerations Companies in distress: A successful turnaround requires decisive action Companies in distress: Bankruptcy process and reporting considerations Companies in distress: Emerging from bankruptcy PwC clients who would like to obtain any of these publications should contact their engagement partner. Prospective clients and friends should contact the managing partner of the nearest PwC office, the name of which can be found at PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, visit PwC s online resource for financial executives.