Financial Reporting for Taxes

Transcription

1 Financial Reporting for Taxes TEI May A&A Update Meeting Acquisition accounting May 8, 2012 Orlando, FL Wendi Christensen Deloitte Tax LLP

2 Agenda Disclosures and supporting work papers Evaluate post-closing adjustments Consider costs of Step 5 the acquisition Step 6 Step 7 Evaluate tax attributes Step 4 Analyze uncertain tax positions Step 3 Record tax consequences of fair value accounting adjustments Step 2 Obtain an understanding of the transaction Step 1 2

3 Financial Reporting for Taxes Step 1: obtain an understanding of the transaction

4 Tax status of enterprise being acquired Taxable Enterprises Generally deferred taxes must be provided on the taxable and deductible temporary differences that arise from a difference between the tax basis of an asset or a liability and its reported amount in the financial statements Each company has an inventory of taxable and deductible temporary differences that will result in DTAs and DTLs Parent company Subsidiary (or <50% owned investee) 4

5 Tax status of enterprise being acquired (cont.) Nontaxable Enterprises (e.g., Partnerships) No deferred taxes are recorded in the partnership s financial statement since tax consequences are borne by its partners If a partner is a taxable enterprise, deferred taxes are provided on temporary differences associated with that partner's interest Deferred tax on temporary difference associated with the partnership investment C Corp 60% Investor No deferred tax recorded in the partnership s financial statements Ptrshp 40% 5

6 Basic model tax effects of basis differences Acquirer recognizes and measures each asset acquired and each liability assumed and any non-controlling interest at its acquisition date fair value Record deferred taxes for estimated future tax effects attributable to temporary differences and carryforwards A temporary difference exists when there is a taxable or deductible difference between (1) the carrying amount of an asset or liability for financial reporting purposes and (2) the tax basis of that asset or liability (must consider the recognition and measurement requirements for tax positions when determining the tax basis) The carrying amount for financial reporting purposes is the same, regardless of the form of the business combination There is a difference in how the tax basis is determined depending on whether the business combination is taxable or nontaxable 6

7 Taxable business combinations Acquirer steps up the target s historical tax bases in the assets acquired and liabilities assumed to fair market value Includes asset acquisitions, stock acquisitions treated as asset acquisitions by election (e.g., 338 elections) and integrated transactions treated as asset acquisitions Section 1060 allocation class Class I Class II Class III Class IV Class V Class VI Class VII Description Cash and near-cash Actively traded property (e.g., publicly traded stock) Mark-to-market assets Inventory Assets not defined as any other class, including PP&E Sec. 197 intangibles, except goodwill and going concern Goodwill and going concern value 7

8 Nontaxable business combinations Acquirer assumes the historical or carry over tax basis of the acquired assets and liabilities assumed FMV accounting for book purposes will result in book/tax basis differences (in addition to the historical differences) Includes stock acquisitions (absent a Section 338 election) and tax-free asset and stock reorganizations (e.g., 368(a)(1)(A) and 368(a)(1)(B)) 8

9 Financial Reporting for Taxes Step 2: record the tax consequences of fair value accounting adjustments

10 Example 1 taxable asset purchase Facts USP buys Target assets for $1,500 USP recognizes and measures each asset acquired and each liability assumed at its acquisition date fair value for both tax and financial reporting purposes Since tax and financial reporting basis will be the same, no temporary differences are expected 10

11 Example 1 taxable asset purchase (cont.) Asset Book basis Tax Basis Difference Tax rate Deferred asset (liability) PP&E $200 $200 40% Intangibles $1,000 $1,000 40% Goodwill $300 $300 40% Total $1,500 $1,500 Debit Credit PP&E $200 Intangibles $1,000 Goodwill $300 Equity $1,500 No deferred taxes recorded no basis differences Temporary differences could arise in the future if depreciation and/or amortization rates for book and tax are different 11

12 Example 2 nontaxable stock purchase Facts USP issues its own shares to T shareholders in exchange for their T shares For financial reporting purposes, USP recognizes and measures each asset acquired and each liability assumed at its acquisition date fair value For tax purposes, USP assumes the historical or carry over tax basis of acquired assets and liabilities assumed The historical temporary differences will be adjusted on account of the fair value accounting adjustments 12

13 Example 2 nontaxable stock purchase (cont.) Asset Book basis Tax basis Difference Tax rate Def tax asset (liability) PP&E $200 $150 $50 40% ($20) Intangibles $1,000 $0 $1,000 40% ($400) Goodwill $300 (1) $0 300 NA Total $1,500 $150 $1,350 ($420) Debit Credit PP&E $200 Intangibles $1,000 Goodwill $720 DTL $420 Equity $1,500 (1) Before considering deferred taxes 13

14 Application to specific basis differences Goodwill In-process R&D Contingent liabilities Deferred revenue Contingent consideration Compensation expenses 14

15 Goodwill Book Goodwill = Consideration transferred + FV of non-controlling acquisition date > FV of identifiable net assets acquired Tax Goodwill = Tax-deductible goodwill Any difference between tax and book goodwill = Component 1 Goodwill = Lesser of Book or Tax Goodwill Component 2 Goodwill 15

16 Goodwill (cont.) Tax Accounting for Component 2 Goodwill A deferred tax asset is recognized for the excess of tax deductible goodwill over book goodwill ASC (d) prohibits recording a deferred tax liability for the excess of the book over tax goodwill when difference is acquired Issue and Potential Risk Historical books may have deferred tax liability or deferred tax asset related to a basis difference in goodwill Any deferred taxes related to historical accounting for goodwill must be removed and reset Component 1 goodwill has no temporary difference on acquisition date Component 2 goodwill may have a DTA for tax goodwill over book goodwill, but no DTL can exist 16

17 Example 3 goodwill Goodwill reset, book basis > tax basis $80 DTL included in liabilities acquired Book Tax Preliminary calculation: Component 1 goodwill (pre-acquisition balance) $400 $200 Component 2 goodwill (pre-acquisition balance) Component 2 goodwill (generated by acquisition) $600 0 Total goodwill $1,000 $200 Journal entry to reverse the existing DTL: DR CR Deferred tax liability $80* Goodwill $80 *DTL =.40 x $200 Book Tax Adjusted calculation: Component 1 goodwill $200 $200 Component 2 goodwill Total goodwill $920 $200 17

18 In-process R&D Financial Reporting Acquired IPR&D will be recognized as an indefinite-lived intangible asset separately from goodwill and recorded at fair value as of the acquisition date The asset will be amortized over the useful life when R&D is complete or expense upon abandonment of project Although it is considered an indefinite lived asset, IPR&D will be expensed over a relatively limited period of time Tax Accounting The amount recorded for an IPR&D intangible asset must be compared with its tax basis to determine whether a temporary difference exists In nontaxable transactions tax basis will typically be zero and a DTL will be recorded for the basis difference 18

19 Contingent liabilities Financial Reporting The acquirer recognizes and measures each liability assumed For Tax Purposes DTA recorded for liabilities deductible when paid or otherwise reduce book income for taxable income calculation (e.g., Sch M adjustment) No DTA is recorded for liabilities that are not deductible when paid (e.g., contingent liabilities assumed in an asset acquisition) Payment of these liabilities results in an increase in tax basis of acquired assets Issue and Potential Risk Accounting systems may not be able to separately track nondeductible payments on liabilities resulting in double deductions: one deduction upon payment and the second through amortization of acquired assets 19

20 Deferred revenue Financial Reporting Revenue related to contracts which extend beyond one reporting period is deferred and taken into account over the life of the contract If deferred revenue represents a future performance obligation, record that obligation at fair value Tax Accounting Deferral of income is only permitted in certain circumstances In a nontaxable business combination, the acquirer should record a DTA for the post purchase accounting balance of deferred revenue In a taxable business combination: Acquirer includes the actual cost to satisfy target s deferred revenue contract in the tax basis of the acquired assets during the period in which the costs are incurred A DTA is recorded for the financial reporting profit margin that will never be taxable 20

21 Contingent consideration Financial Reporting Record at fair value (regardless of likelihood of payment) and classify as a liability or in equity Liability-classified earn-out arrangements will be re-measured to FV at each balance sheet date; changes are recognized in post-acquisition income statement Tax Accounting In a nontaxable business combination, payment of contingency generally results in additional purchase price for target stock Several exceptions to recording deferred taxes on outside basis differences in the stock of a subsidiary In a taxable business combination, payment of contingency generally results in additional amortizable or depreciable tax basis in target assets The amount at closing would be expected to eliminate any initial basis differences in the target assets 21

22 Accrued compensation Financial Reporting Acquirer recognizes and measures accrued liabilities for compensation and benefits Some of the compensation may have accrued as a result of the business combination Tax Accounting Record a DTA for compensation expenses that will be deductible when paid Accrued compensation expenses may not be deductible Tax deductions may be limited under Section 280G Additional analysis may be required to identify the tax deductible payments in each period 22

23 Financial Reporting for Taxes Step 3: analyze uncertain tax positions

24 Uncertain tax positions generally Financial Reporting A tax position is first evaluated for recognition based upon its technical merits. Tax positions that meet a recognition criterion are then measured to determine an amount to recognize in the financial statements. ASC Acquirer can only change the recognition and measurement of target s historic tax positions based upon new information and not from a new evaluation or new interpretation by management of information that was available in a previous financial reporting period. ASC and Note: In order to make changes in recognition (e.g., new court case) or measurement (e.g., different settlement profile), identification of new information is required 24

25 Uncertain tax positions acquired entities Changes in an acquired entity s uncertain tax positions: After the acquisition date, all adjustments to an acquired entity s uncertain tax positions are recorded in income tax expense, with one exception: If the company is still finalizing its accounting during the measurement period, and an adjustment is required that is based on new information about facts and circumstances that existed as of the acquisition date, then the adjustment is recorded to goodwill It is important to: Finalize tax due diligence before measurement period ends Refine UTB analysis before measurement period ends Document all information available and considered at the acquisition date 25

26 Financial Reporting for Taxes Step 4: evaluate tax attributes

27 Valuation allowances Acquirer Acquirer s removal (or reversal) of its valuation allowance or any adjustment to tax-related balances as a result of a business combination is recorded as a component of income tax expense and not included as part of acquisition accounting Target Adjustments to the target s historical valuation allowance for DTAs at the date of acquisition (to reflect the fact that the acquirer and target will be filing a consolidated tax return) are reflected as adjustments to goodwill See discussion of measurement period for subsequent changes 27

28 Valuation allowances section 382 limitations Section 382 generally places a limitation on the amount of net operating losses and other tax attributes arising before a change in ownership that may be used to offset taxable income after such a change A business combination is an ownership change that typically results in a Section 382 limitation Considerations: 1. What amount of DTA should be recorded for tax attributes subject to limitation? A DTA should be recorded for the maximum amount of net operating loss that is mathematically possible of being used (sum of annual limits and NUBIG) 2. How does the limitation affect the valuation allowance and uncertain tax benefits considerations? A valuation allowance should be used to reduce the above DTA to the amount of tax benefits from the net operating loss that is more likely than not to be realized The presentation of the DTA/UTPs may be affected by whether the acquiring company records UTPs using the net or gross method 28

29 Indemnification by seller Financial Reporting Acquirer recognizes an indemnification asset (subject to realizability) at the same time and on the same basis as the indemnified item Tax Accounting The indemnification receivable is usually not a temporary difference because it is considered an adjustment to purchase price and as such is not taxable 29

30 Example 4 indemnification and UTB Facts Acquirer purchases Target Target has an UTB liability (indemnified by a previous owner) of $100 related to a federal tax issue (not MLTN to be realized) Under the purchase agreement, Target s prior owner indemnifies Acquirer against losses related to the UTB Day 1 accounting DR CR Indemnification receivable $100 UTB liability $100 Settlement for $75 Indemnification expense $25 Indemnification receivable $25 UTB liability $100 Tax expense $25 Cash $75 30

31 Changes to jurisdictional footprint Acquirer s historical state tax footprint can be changed by the transaction Assume an acquirer operating in Nevada with no deferred state taxes but substantial temporary differences acquires a target company in California Acquirer now required to file a combined California return with target company Acquirer must record deferred taxes for California state tax (on its own historical temporary differences) even though no state taxes were previously recognized Any change in the measurement of existing deferred tax items of the acquirer as a result of the acquisition are recorded outside of the business combination accounting as a component of income tax expense Measurement of target s deferred taxes must consider the expected state combined and consolidated filings and the period when the combined filings will commence Adjustments to target s historical deferred taxes are accounted for as part of the business combination 31

32 Financial Reporting for Taxes Step 5: evaluate costs of the acquisition

33 Transaction costs Financial Reporting Under ASC 805, transaction costs are expensed as incurred Tax Treatment Costs are either: Capitalized into asset or stock basis or Capitalized as a separate non-amortizable asset (for tax-free acquisitions) 33

34 Transaction costs pre-acquisition period View 1 Don t Anticipate Closing Pre-closing reporting period record tax consequences assuming transaction won t close (e.g., assume costs not yet deducted will eventually become deductible) Actual tax consequences are determined and recorded at closing View 2 Record Expected Tax Consequences Pre-closing reporting period if transaction is more-likely-than-not (MLTN) to close, record expected tax consequences of transaction costs according to the MLTN form of the transaction (e.g., taxable or nontaxable business combination). If transaction is not MLTN to close, then record tax consequences assuming transaction won t close (see View 1 above). 34

35 Example 5 transaction costs Facts During Q3 2010, Acquirer begins due diligence for acquisition of Target stock Acquisition is expected to be structured as a non-taxable business combination and expected to close in Q For financial reporting purposes, Acquirer expenses $10,000 of transaction costs during Q3 and Q4 of 2010 A preliminary tax analysis of costs determines the following: Non-deductible costs = $6,000 (added to tax basis of Target stock) Deductible costs = $4,000 (deductible upon closing of the transaction) Tax rate is 40% 35

36 Example 5 transaction costs (cont.) View 1 Don t Anticipate Closing DR DR Transaction expense $10,000 Cash $10,000 Deferred tax asset $4,000 Deferred tax expense $4,000 Adjusting entry at closing Deferred tax expense $4,000 Deferred tax asset $4,000 Current tax liability $1,600 Current tax expense Net 2,400 $1,600 36

37 Example 5 transaction costs (cont.) View 2 Record Expected Tax Consequences DR CR Transaction expense $10,000 Cash $10,000 Deferred tax asset $1,600 Deferred tax expense $1,600 At close Deferred tax expense $1,600 Deferred tax asset $1,600 Current tax liability $1,600 Current tax benefit Net zero $1,600 37

38 Example 6 transaction costs Facts During Q1 2010, Acquirer announces its intent to acquire Target and expects to close in Q (expected to be structured as a non-taxable transaction) In Q2, Acquirer determines that due to market conditions it does not expect to close the transaction In Q3, Acquirer acquires Target For financial reporting purposes, Acquirer estimates it will incur $10,000 of transaction costs in 2010 A preliminary tax analysis of costs determines the following: Non-deductible costs = $6,000 Deductible costs = $4,000 (deductible upon closing of the transaction) Assume 40% tax rate 38

39 Example 6 transaction costs (cont.) View 1 Q1 Q2 Q3 Actual Pre-tax income $100,000 $100,000 $100,000 $100,000 Nondeductible transaction costs 6,000 6,000 Net tax to be provided 40,000 40,000 42,400 42,400 Estimated effect on AETR (1) 40% 40% 42.4% 42.4% View 2 Q1 Q2 Q3 Actual Pre-tax income $100,000 $100,000 $100,000 $100,000 Nondeductible transaction costs 6,000 6,000 6,000 Net tax to be provided 42,400 40,000 42,400 42,400 Estimated effect on AETR (1) 42.4% 40% 42.4% 42.4% (1) Assuming the transaction costs are not considered significant, unusual, or extraordinary ASC

40 Financial Reporting for Taxes Step 6: evaluate post-closing adjustments

41 Measurement period revisited Measurement period is the period after the acquisition date during which the acquirer may adjust the provisional amounts recognized for a business combination to reflect new information obtained about facts and circumstances that existed as of the acquisition date Measurement period ends as soon as the acquirer receives the information it was seeking or learns that more information is not obtainable (should not exceed one year from the acquisition date) Acquirer revises comparative information for prior periods presented in financial statements as needed After the measurement period ends, the acquirer revises the accounting for a business combination only to correct an error 41

42 Example 7 measurement period adjustments Acquisition Closes Measurement Period Closes 6/30/09 1/1/10 1/1/09 3/31/09 9/30/09 Facts 10Q includes tax estimates Tax acquisition accounting finalized On January 1, 2009, Company X acquired 100% of Target Company X collects jurisdictional tax rate information and analyzes Target s deferred tax assets and liabilities Company X closes FY 2009 Q1 with estimates for taxes and discloses in its business combination footnote that data is still being gathered to finalize the tax accounting In June 2009, Company X gathers all information needed to finalize tax adjustments associated with the transaction (for facts that existed as of the acquisition date) and records the entries in its June close In July 2009, Company X files its Form 10Q and discloses the tax accounting has been finalized for the acquisition of Target 42

43 Example 7 measurement period adjustments (cont.) Acquisition Closes Measurement Period Closes 1/1/09 3/31/09 6/30/09 9/30/09 1/1/10 (1) Additional Facts 10Q includes tax estimates Tax acquisition accounting finalized In June 2009, in connection with finalizing tax accounting related to the acquisition, Company X management identifies new information New information (which existed at acquisition date) makes a portion of the acquired entity's deferred tax assets not MLTN of being realized Company X s management concludes an adjustment is needed to increase the valuation allowance What journal entry is necessary? 43

44 Example 7 measurement period adjustments (cont.) Acquisition Closes Measurement Period Closes 1/1/09 3/31/09 6/30/09 9/30/09 1/1/10 (2) Additional Facts 10Q includes tax estimates Tax acquisition accounting finalized In September 2009, management reevaluates acquired entity s DTA valuation allowance to consider new facts (dramatic downturn in business) Management concludes an increase in the acquired entity s valuation allowance is needed since DTAs are not MLTN of being realized What journal entry is necessary? 44

45 Example 7 measurement period adjustments (cont.) Acquisition Closes Measurement Period Closes 1/1/09 3/31/09 6/30/09 9/30/09 1/1/10 4/30/10 (3) Additional Facts 10Q includes tax estimates Tax acquisition accounting finalized In April 2010, management discovers errors in the tax basis used to measure deferred taxes in acquisition accounting How should the adjustment be recorded? Error are corrected by adjusting misstated accounts (i.e., deferred taxes and goodwill) If the correcting entry was recorded to income tax expense, tax expense would be either over or understated and goodwill will remain recorded at an incorrect amount Entry to deferred taxes and goodwill may be recorded in the year the error is discovered (if amounts are material, restatement of prior periods may be necessary) Adjustment most likely will be go to goodwill even when goodwill has been impaired 45

46 Example 8 contingent consideration Facts (Stock Acquisition) Acquirer purchases Target stock for $200 plus a contingent payment with a fair value of $50 Fair value of the identifiable assets is $200 and the tax basis is $25 Tax rate is 40% Day 1 accounting DR CR Assets $ 200 Goodwill $ 120 Cash $ 200 Contingent consideration liability $ 50 Deferred tax liability ($200-$25 40%) $ 70 46

47 Example 8 contingent consideration (cont.) Scenario 1 settle at the initial amount accrued: DR CR Contingent consideration liability 50 Cash 50 Scenario 2 settle at $50 greater than initial amount accrued: Pre-tax expense 50 Contingent consideration liability 50 Cash 100 In non-taxable business combinations, settlement of contingent consideration classified as a liability for an amount greater than the initial amount is recorded as an expense for book purposes and an increase in stock for tax purposes An unfavorable permanent difference is created since ASC prohibits recognition of a DTA when tax basis exceeds book basis in the stock when the temporary difference will not be reversed in the foreseeable future 47

48 Example 8 contingent consideration (cont.) Scenario 3 settle at $40 less than initial amount: DR CR Contingent consideration liability $ 50 Income $ 40 Cash $ 10 Settlement for an amount less than the initial amount is recorded as income for book purposes and as a decrease in the stock for tax purposes A favorable permanent difference may arise if (1) target is a domestic corporation; (2) stock basis difference can be eliminated in a tax-free manner (e.g., liquidation) and (3) Acquirer intends to realize stock basis difference [ASC exception to DTL applicable to domestic sub] Other exceptions might apply to a foreign target company 48

49 Example 9 contingent consideration Facts (Taxable Business Combination) Acquirer purchases Target s assets for $200 plus a contingent payment with a fair value of $50 Tax rate is 40% Day 1 accounting DR CR Assets $ 200 Goodwill $ 50 Cash $ 200 Contingent consideration liability $ 50 At acquisition date, no temporary differences considered to exist in Target s assets since payment of the contingent consideration ( expected ) results in additional amortizable/depreciable tax basis in goodwill 49

50 Example 9 contingent consideration (cont.) Scenario 1 settle at the initial amount accrued: DR CR Contingent consideration liability $ 50 Cash $ 50 Scenario 2 settle at $50 greater than initial amount accrued: Expense $ 50 Contingent consideration liability $ 50 Cash $ 100 Deferred tax asset $ 20 Deferred tax provision $ 20 In a taxable business combination, settlement of contingent consideration classified as a liability for an amount greater than the initial amount is recorded as an expense for book purposes and an increase in asset basis for tax 50

51 Contingent consideration taxable business combination Scenario 3 settle at $40 less than initial amount: DR CR Contingent consideration liability $ 50 Income $ 40 Cash $ 10 Deferred tax provision $ 16 Deferred tax liability $ 16 In a taxable business combination, settlement of contingent consideration classified as a liability for an amount less than the initial amount is recorded as income for book purposes and as decreased asset basis for tax purposes A deferred tax liability is recorded on the temporary difference resulting from the immediate deduction of expected tax basis 51

52 Financial Reporting for Taxes Step 7: disclosures and supporting documentation

53 Disclosure requirements Under ASC , the acquirer shall disclose information that enables users of its financial statements to evaluate the nature and financial effect of a business combination that occurs either: During the current reporting period; or After the reporting date but before the financial statements are issued Paragraphs 2 through 8 detail specific disclosure requirements with respect to the initial accounting for a business combination Under ASC , if the initial accounting is incomplete, an acquirer shall disclose: The reasons why the initial accounting is incomplete The assets, liabilities, equity interests, or items of consideration for which the initial accounting is incomplete The nature and amount of any measurement period adjustments recognized during the reporting period 53

54 Sample UTB tabular rollforward (Dollar amounts in millions) Balance at January 1 $114 $66 $52 Additions for tax positions of prior years Reductions for tax positions of prior years Additions based on tax positions related to current year Lapse of statute of limitations Settlements Foreign exchange translation -3 3 Positions assumed in ABC transaction 117 Balance at December 31 $285 $114 $66 54

55 Sample business combination footnote The purchase accounting adjustments are preliminary and subject to revision. At this time, except for the items noted below, the Company does not expect material changes to the value of the assets acquired or liabilities assumed in conjunction with the transaction. Specifically, the following assets and liabilities are subject to change: Intangible management contracts were valued using preliminary December 1, 2009 AUM and assumptions. The value of such contracts may change, primarily as the result of updates to AUM and those assumptions; As management receives additional information, deferred income tax assets and liabilities and other assets, due from and to related parties, and other liabilities may be adjusted as the result of changes in purchase accounting and applicable tax rates 55

56 Supporting process and documentation Internal controls Frequent and formal interaction between accounting and tax departments Process and controls for tax effecting fair value adjustments consider technology used, resources involved, review procedures, etc. Analytical review of acquisition accounting (for instance, ETR on goodwill adjustments) Education of tax department personnel Integration with tax provision calculations Other tools work plans, process memos, etc. Technical analysis Obtain and review financial accounting documentation, which will often include technical memoranda Memorialize tax analysis of acquisition accounting issues and conclusions on tax provision and tax return treatment 56

57 Supporting process and documentation (cont.) Data considerations Particularly in a nontaxable acquisition, fair value accounting may result in the loss of historic data that will still be required for tax purposes e.g., historic debt discounts Identify such data needs during acquisition accounting and implement plans to maintain necessary data External audit Consider auditability of the acquisition accounting work product Develop work papers for external auditor review (opening balance sheet, tax effect of fair value adjustments, tax attribute analysis and adjustments, technical memos, process documentation) 57

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