By Glenn Richard James, JD, CPA Accounting standards require that deferred taxes

be recorded on every difference between the book and tax basis of assets and liabilities acquired in an acquisition save one: the excess of goodwill recorded for financial statement accounting over the tax basis of goodwill acquired.

The principles can be tricky to apply, especially in situations where the deal is structured as an asset purchase versus a stock purchase, or when there is a bargain purchase price. In either structure, each asset and liability acquired is separately fair valued to determine the basis of acquired assets and liabilities at the acquisition date; and there is no limit on the fair value of net assets acquired. However, for income tax purposes, only the asset purchase structure gives rise to a fair valuing of assets, and even then the net value of assets acquired is limited to the purchase price. Conversely, in a stock purchase, assets and liabilities come over at the seller’s tax bases immediately prior to the transaction.

When determining the basis differences of assets and liabilities acquired in a transaction, the crucial next step is to determine the tax bases of assets and liabilities acquired, which must then be compared to the fair values to determine opening temporary differences and then the deferred tax amounts in respect of those differences. In either structure, the book basis of assets and liabilities in the accounts of the target immediately prior to the

acquisition are not likely to constitute a useful proxy for the tax basis of those assets and liabilities.

It is important to note that there are special issues involved in the fair valuation of liabilities. Certain liabilities are not recognized as such for income taxes, and, consequently, will always give rise to an opening deferred tax asset. For example, there is no tax liability for an ASC 840 (formerly FAS 13) rental obligation or a capital lease obligation in respect of a lease treated as an operating lease for income taxes. Then there are the liabilities for deferred taxes, which are ignored and do not cause the recognition of further temporary differences.

The opposite side of any entry to record deferred taxes will be to the goodwill asset or the bargain purchase gain, whichever is present. The net deferred tax entry will result in an adjustment as follows: recording a net deferred tax asset will decrease goodwill or increase a bargain purchase gain; recording a net deferred tax liability will increase goodwill or decrease, or eliminate a bargain purchase gain.

An example should be useful. Assume a stock purchase structure for a cash purchase price of $3,500,000. The tax basis in loans acquired is $3,000,000. The loans are carried on the seller’s books at a net value of $2,500,000. Fair value of

Attention to Detail: Deferred Tax Accounting in an Acquisition is Essential

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those loans is determined to be $2,400,000. There is an ASC 840 lease obligation of $100,000. Deposit account liabilities have a tax basis of $2,000,000 and a fair value of $1,900,000. Securities have a tax basis of $3,000,000 and a fair value of $2,700,000. There are no other temporary differences. The seller has recorded a net deferred tax asset of $440,000. The proper tax rate to apply in determining deferred taxes and liabilities is 40%.

Analysis Tax Fair Temporary Basis Value DifferenceLoans $3,000,000 $2,400,000 $600,000Securities 3,000,000 2,700,000 300,000Deposits (2,000,000) (1,900,000) (100,000)ASC 840 liability - 0 - (100,000) 100,000Net $4,000,000 3,100,000 $900,000Deferred taxes at 40% 360,000Net assets acquired $3,460,000SummaryPurchase price paid $3,500,000Net fair value of assets acquired 3,460,000Goodwill $40,000

Thus, the transaction generates goodwill of $40,000 and not the $400,000 of goodwill that would be calculated by looking only at the “visible” assets acquired and liabilities assumed other than deferred taxes, nor is it the $40,000 of bargain purchase gain that would be calculated by including the seller’s net deferred tax asset as an asset acquired.

As can be observed in the example, getting the deferred taxes wrong can easily move the result of the transaction from bargain purchase to goodwill and prove an embarrassment to the deal negotiator. Make sure it doesn’t happen to you.

Glenn Richard James, a partner with BDO USA LLP, is a financial services tax professional. His practice experience includes federal and state corporate income, franchise and shares tax planning, incentive compensation planning and design; taxation of and accounting for share based payment; and financial instrument taxation.

© 2012 BDO USA, LLP. All rights reserved.

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