Deferred tax and business combinations in IAS 12

Deferred tax and business combinations

Deferred tax and consolidated accounts

Business combinations offer an added level of complexity to the reporting of deferred taxes. This section considers a number of practical issues that can arise, specifically:

• whether deferred tax should be recognised on intangible assets acquired in a business combination
• when deferred tax arises on assets acquired in a business combination, whether the tax rate to be applied is that of the acquiree or acquirer
• when deferred tax is recognised in a business combination, whether this leads to an immediate impairment of goodwill
• the provision of deferred tax on unrealised intra-group profits eliminated on consolidation.

Intangible assets arising on a business combination

IFRS 3 (Revised 2008) requires intangible assets acquired in a business combination to be recognised at their fair value in the consolidated statement of financial position. Tax rules on intangible assets vary from jurisdiction to jurisdiction.

Understanding these rules is necessary to identify the tax bases of intangible assets and, accordingly, any temporary difference that may arise. For example, in certain jurisdictions tax is calculated using the separate financial statements of the members of the group, and not the consolidated accounts.

Hence, if an asset arises only on consolidation, its tax base will be nil. This is because, the income earned whilst the asset is used will be taxable and there will be no tax deductions available against that income from the use of the asset. Equally, if such an asset were sold, there would be usually no tax deduction on disposal.

This results in a temporary difference equal to the carrying value of the asset on initial recognition in the consolidated accounts. As the intangible asset and the related deferred tax arise on a business combination, the other side of the entry is to goodwill under IAS 12.66, see Deferred tax allocated to business combinations in Allocating the deferred tax charge or credit.

As the intangible asset is amortised, the temporary difference will decrease. The reduction in the deferred tax liability is recognised in profit or loss. The recognition of this deferred tax credit to profit or loss reduces the impact of the amortisation of the intangible asset on profits for the year.

Case – Customer contracts valuation on acquisition

Both Companies A and B are domiciled in Country X and pay corporation tax at 23%. Company A prepares IFRS group accounts. In Country X, taxes are calculated based on the separate financial statements of the group entities rather than the consolidated financial statements. Year 1 On 31 December 20X1, Company A acquires Company B for CU1,000,000. At that time, Company B has net assets of CU500,000. Company A undertakes a fair value exercise and does not identify any fair value adjustments to the recognised net assets of Company B, however it does identify a number of customer contracts that have a total fair value of CU250,000. In preparing its consolidated accounts, Company A must recognise this identifiable intangible asset and provide deferred tax on the difference between the asset’s carrying amount of CU250,000 and tax base of nil. This leads to a deferred tax liability of CU57,500 using the applicable tax rate of 23%. Therefore in the consolidated accounts of Company A, goodwill is recognised amounting to CU307,500 (CU1,000,000 – CU500,000 – CU250,000 + CU57,500). Year 2 At 31 December 20X2, the consolidated accounts show accumulated amortisation of CU50,000. Therefore the intangible asset has an accounting base of CU200,000, which is also the taxable temporary difference at 31 December 20X2. There is, therefore, a resulting deferred tax liability of CU46,000 (CU200,000 × 23%). The amortisation of CU50,000 and the reduction in the deferred tax liability of CU11,500 (CU50,000 × 23%) will both be recognised in profit or loss.

Whose tax rate should be applied to fair value adjustments arising in a business combination?

The tax base of an asset is the amount that will be deductible for tax purposes in future periods (IAS 12.7).

The tax base of an asset may depend on whether the asset is intended to be used or sold. As set out in The manner of tax recovery and blended rate, it is important to establish how an entity will recover the carrying amount of its assets, because this may affect the tax base and the tax rate to be applied.

When considering the recognition of deferred tax on assets, the principle in IAS 12 is to consider whether the recovery of the asset will lead to future economic benefits that are taxable. Assuming that a group intends to continue to hold the acquired asset and use it to generate taxable profits in the acquired subsidiary, it is the tax rate that applies to that subsidiary’s taxable profits that should be used in calculating the relevant deferred tax balance.

Case – Determination of tax rate

Company A acquires Company B on 17 October 20X1. Both Company A and B are trading companies, and for the purposes of IFRS 3 this acquisition is treated as an acquisition of B by A. Company A does not pay tax, ie it is subject to a nil rate of tax in its jurisdiction. Company B pays tax at a rate of 23%. On the acquisition, Company A performs a fair value exercise which identifies an intangible asset with a fair value of CU250,000. This intangible asset has a tax base of nil, ie no deductions will be available against taxable profit as this asset is recovered. Therefore, as the intangible asset has a carrying value of CU250,000 and a tax base of nil, it has a temporary difference of CU250,000. As the intangible asset relates to the subsidiary, its carrying value will be recovered through that subsidiary making future taxable profits, which will be taxed at a rate of 23%. Therefore a deferred tax liability of CU57,500 (CU250,000 × 23%) should be provided. The same analysis holds true for other fair value adjustments recognised in a business combination.

Can the recognition of deferred tax on intangibles create goodwill which is immediately impaired?

In some situations the recognition of deferred tax on an intangible asset acquired in a business combination can result in a goodwill figure which appears to be immediately impaired.

IAS 36 ‘Impairment of Assets’ (IAS 36) requires goodwill to be tested at least annually for impairment.

Goodwill is impaired where the recoverable amount of the cash-generating unit (CGU) to which it is allocated is lower than its carrying amount. Recoverable amount is the higher of the value in use and fair value less costs to sell (IAS 36.6 refers to costs of disposal but it has the same meaning as costs to sell).

In calculating value in use, IAS 36.50 states:

‘Estimates of future cash flows shall not include: a) cash inflows or outflows from financing activities; or b) income tax receipts or payments.’

As a result, the value in use calculation cannot include tax cash flows and is, therefore, based on pre-tax cash flows and a pre-tax discount rate. IAS 36.75 separately requires the carrying value of a CGU to be calculated in a manner consistent with the determination of the recoverable amount of that CGU.

Hence, to be consistent with the manner in which the recoverable amount is calculated, the deferred tax liability arising in a business combination should not be included in the net assets of the CGU tested for impairment. This can give rise to potential problems as demonstrated by the following example.

Case – Impairment and deferred taxes

Company A acquires Company B. Both Company A and B are trading companies, and for the purposes of IFRS 3 this acquisition is treated as an acquisition of B by A. The fair value of the consideration, all cash, given by Company A is CU1,000. The only identifiable asset in the business combination is an intangible asset with a value of CU1,000. The intangible asset was not recognised in the accounts of Company B. The tax base of that intangible asset is nil and both Company A and Company B pay tax at the rate of 23%. Therefore, there is a taxable temporary difference arising on the recognition of this intangible of CU1,000 and a deferred tax liability of CU230 must be recognised (CU1,000 × 23%). Thus, this deferred tax liability arises as a result of recognising and fair valuing the identified intangible asset acquired. This transaction would be recognised in the consolidated financial statements as follows: Assuming that the fair value of the consideration transferred was arrived at using value in use calculations and that the CU1,000 represented a fair price for the business, the need to exclude the deferred tax liability from the net assets of the CGU will result in an apparent immediate impairment charge of CU230. This is because the value in use calculations to support the purchase price would take account of the expected future tax cash flows. However, as set out above, IAS 36 prohibits the inclusion of tax balances and tax cash flows in the net assets allocated to the CGU and the calculation of its value in use. The value of the net assets assigned to this CGU is CU1,230, ignoring the deferred tax liability derived above (Intangible asset CU1,000 + Goodwill CU230). As the value in use calculation supported a consideration of CU1,000 there is an apparent impairment of CU230 (CU1,230 – CU1000). A number of arguments exist to avoid this apparent need for an immediate impairment charge and these are set out below.

Was a fair price paid? Is the CGU’s value supported by its fair value less costs to sell?

The assessment of whether goodwill is impaired will depend on the particular circumstances of the business combination. For example, there may be circumstances where the payment for the business does not represent a fair price for the acquired business, in which case an immediate impairment of the goodwill may arise.

The case above assumed that the payment for the acquired business represented a fair price. Given this assumption, it is clear that there should not be an immediate impairment charge because the combined group has not suffered a loss. Indeed, this assumption provides a justification for not recognising this impairment charge.

Given that we have assumed that the CU1,000 is a fair price for the business combination, IAS 36 would determine this as the fair value less costs to sell of the acquired business, if the costs to sell were likely to be immaterial. The recoverable amount would still be CU1,000. However, the net assets of the CGU would include the deferred tax liability, as the fair value less costs to sell calculation is usually a post-tax assessment. There would, therefore, be no immediate impairment charge.

This may help justify the carrying value of the goodwill immediately after acquisition. However, in circumstances where it is difficult to continually monitor the fair value less costs to sell of a CGU, this is unlikely to provide an adequate ongoing solution. Where there is an absence of external transactions against which this valuation might be benchmarked, it may prove difficult to continually monitor the fair value less costs to sell of a CGU, and, therefore, unable to avoid an impairment of goodwill indefinitely.

Does significant headroom exist to justify the carrying value of the goodwill?

The example used above is a very simplified example of a business combination where there is no headroom in the value-in-use calculation leading to an assessment that there is an apparent immediate impairment of the goodwill arising on the business combination. In practice, it is logical that a purchaser might expect to make more profits from the acquisition than the fair value paid for that acquisition.

As a result, and because the value in use calculation is entity-specific, even though the deferred tax is ignored in determining the carrying amount of the CGU there may still be sufficient headroom such that the goodwill is not impaired.

How else can the carrying value of goodwill be justified?

Where it is not possible to justify the carrying value of the goodwill in the ways described above, it may still be possible to avoid an inappropriate impairment charge.

IAS 36.76, which amplifies the requirements of IAS 36.75 referred to above, requires that the carrying amount of a cash-generating unit:

1. includes the carrying amount of only those assets that can be attributed directly, or allocated on a reasonable and consistent basis, to the cash-generating unit and will generate the future cash inflows used in determining the cash-generating unit’s value in use and

2. does not include the carrying amount of any recognised liability, unless the recoverable amount of the cash-generating-unit cannot be determined without consideration of this liability.

This is because fair value less costs to sell and value in use of a cash-generating unit are determined excluding cash flows that relate to assets that are not part of the cash-generating unit and liabilities that have been recognised (see IAS 36.28 and IAS 36.43).

This appears to restrict the inclusion of a deferred tax liability in the calculation of value in use.

However, IAS 36.78 further states (emphasis added):

‘It may be necessary to consider some recognised liabilities to determine the recoverable amount of a cash-generating-unit. This may occur if the disposal of a cash-generating unit would require the buyer to assume the liability. In this case, the fair value less costs of disposal (or the estimated cash flow from ultimate disposal) of the cash-generating unit is the price to sell the assets of the cash-generating unit and the liability together, less the costs of disposal. To perform a meaningful comparison between the carrying amount of the cash-generating unit and its recoverable amount, the carrying amount of the liability is deducted in determining both the cash-generating-unit’s value in use and its carrying amount.’

Whilst this paragraph is relevant to the assessment of the fair value less costs to sell, it could be interpreted to allow some flexibility in applying the requirements of the standard when considering which assets and liabilities can be included in the carrying value of a CGU.

It can be argued that, in order to undertake a meaningful impairment calculation, it is necessary to include this deferred tax liability in the net assets of the cash generating unit to which this goodwill relates.

However, it would only be appropriate to include this deferred tax liability in the carrying amount of the CGU. Other deferred tax assets and liabilities arising on the business combination must be excluded from the net assets of the CGU in accordance with IAS 36.50.

Deferred tax and intra-group profits

IAS 12 requires the recognition of deferred tax on all unrealised intra-group profits. Where, for example, a company in the group has sold inventory to another group company and this inventory remains unsold at the year end, the unrealised profit on this intra-group transaction should be eliminated on consolidation.

Deferred tax then has to be provided on the difference between the carrying value of that inventory, which will be after elimination of the intra-group profit, and its tax base, which will be the cost of the inventory in the acquiring company, ie before elimination of the intra-group profit.

Where the two group companies pay tax at different rates, the acquiring company’s tax rate should be applied to this temporary difference to calculate the deferred tax balance. This is because the tax rate and tax base of the asset must be consistent. The tax base is the deduction that will be available in the future.

This will accrue to the acquiring company. Accordingly the applicable tax rate is also that of the acquiring company.

Case – Intra-group inventory sale

Company A purchases inventory for CU10,000 on 30 November 20X1. On 15 December 20X1 Company A sells this inventory to its wholly-owned subsidiary Company B for CU12,500. At 31 December 20X1 the inventory remains unsold by Company B. Company A pays tax at the rate of 23%. Company B is domiciled in a country where the corporation tax rate is 20%. Company B will record the cost of the inventory as a deduction against future taxable profits. In Company A’s separate financial statements, a current tax liability has been recognised related to this sale of inventory to Company B amounting to CU575 (CU2,500 x 23%). Company A prepares consolidated financial statements in which the inventory is restated to CU10,000, ie the intra-group profit of CU2,500 is eliminated. This stock has an accounting base of CU10,000 and a tax base of CU12,500. There is therefore a deductible temporary difference of CU2,500 (CU12,500 – CU10,000). Therefore, a deferred tax asset of CU500 is recognised (CU2,500 × 20%), subject to there being sufficient future taxable profits against which this deferred tax asset can be recovered.

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