Most corporate acquisitions involve a transaction between the acquiring corporation and the shareholders of the acquired corporation. Although the board of directors and management of the acquired company are usually deeply involved in discussions andnegotiations, the acquisition usually takes place with the acquiring corporation giving some type of consideration to the shareholders of the acquired corporation in exchange for their stock. From a legal viewpoint, the acquired corporation remains a legally separate entity that has simply had a change in the makeup of its shareholder group.
The income tax treatment of corporate acquisitions follows these legal entity notions. In many acquisitions, the acquired company does not restate its assets and liabilities for tax purposes to reflect the amount that was paid by the acquirer to shareholders for their shares of common stock. Instead, the tax basis of assets and liabilities of the acquired company before the acquisition carries over after the acquisition(termed a nontaxable reorganization by the Internal Revenue Code
The preceding examples ignored the tax effects to focus on the acquisition and consolidation process. However, the following illustrates how deferred taxes would be recognized on a given difference between fair and book values. Assume that inventory had a book value of $70 and a fair value of $80; the tax rate is 35%. In the fair value allocation at the date of acquisition (and in the elimination entries during consolidation) inventory is increased by $10 and a deferred tax liability is increased by $3.50 ($10 3 35%). The deferred tax liability is accrued at the date of acquisition to recognize the increase in tax liability when the inventory is sold in the future. If during the next year the subsidiary sells the inventory at its $80 fair value, the subsidiary will have a pretax profit (for book purposes) and a taxable income (for tax purposes) of $10 However, the consolidated financial statements recognize no profit on the sale because of two counterbalancing effects: the subsidiary shows a $10 pretax profit, but the $10 additional cost of goods sold (the $10 extra paid by the parent to acquire the inventory) is recognized through the elimination process. Accordingly, consolidated pretax profit on the transaction is zero; thus, consolidated income tax expense is zero. However, the tax basis of the inventory has not been ‘‘stepped up’’ to $80 at the date of acquisition. Therefore, the subsidiary must pay taxes of $3.50 when the inventory is sold (the reversal of the deferred tax liability).
Consolidation of Unconsolidated Affiliates and Joint Ventures
In some cases, firms have joint ventures or minority-owned affiliates that comprise strategically important components integral to the operations of the firm but that are not consolidated. To get a more complete picture of the economic position and performance of the firm, you may want to assess the firm after consolidating all important minority-owned affiliates. For example, firms frequently work together in joint ventures to carry out their business activities. These companies do not consolidate the financial statements of the joint ventures with their financial statements, but instead use the equity method to account for the joint ventures because they are not majority-owned by the firm.
The procedure to consolidate unconsolidated affiliates and joint ventures follows the consolidated worksheet illustrated earlier. Basically, you eliminate the investment account, add the assets and liabilities of the affiliate or joint venture to the parent’sassets and liabilities, adjust the assets and liabilities for any unamortized differences between the affiliate or joint venture’s book and fair values (if that information is available in the notes to the parent’s financial statements), and recognize the noncontrollinginterest in net assets.
Proportionate consolidation is an alternative to full consolidation. Under proportionate consolidation, the investor’s share of the affiliate’s assets and liabilities appears in separate sections on the asset and liabilities sides of the balance sheet, with the equity investment account eliminated, and no noncontrolling interest is recognized. This alternative is particularly appealing for firms that enter into joint ventures in which ownership of the venture is split equally between two firms. Under U.S. GAAP, firms account for investments in joint ventures using the equity method because these investments fall between minority, active investments and majority, active investments. IFRS permits use of proportionate consolidation for joint ventures, arguing that proportionate consolidation better captures the economics of transactions in which joint control is present
The income tax treatment of corporate acquisitions follows these legal entity notions. In many acquisitions, the acquired company does not restate its assets and liabilities for tax purposes to reflect the amount that was paid by the acquirer to shareholders for their shares of common stock. Instead, the tax basis of assets and liabilities of the acquired company before the acquisition carries over after the acquisition(termed a nontaxable reorganization by the Internal Revenue Code
The preceding examples ignored the tax effects to focus on the acquisition and consolidation process. However, the following illustrates how deferred taxes would be recognized on a given difference between fair and book values. Assume that inventory had a book value of $70 and a fair value of $80; the tax rate is 35%. In the fair value allocation at the date of acquisition (and in the elimination entries during consolidation) inventory is increased by $10 and a deferred tax liability is increased by $3.50 ($10 3 35%). The deferred tax liability is accrued at the date of acquisition to recognize the increase in tax liability when the inventory is sold in the future. If during the next year the subsidiary sells the inventory at its $80 fair value, the subsidiary will have a pretax profit (for book purposes) and a taxable income (for tax purposes) of $10 However, the consolidated financial statements recognize no profit on the sale because of two counterbalancing effects: the subsidiary shows a $10 pretax profit, but the $10 additional cost of goods sold (the $10 extra paid by the parent to acquire the inventory) is recognized through the elimination process. Accordingly, consolidated pretax profit on the transaction is zero; thus, consolidated income tax expense is zero. However, the tax basis of the inventory has not been ‘‘stepped up’’ to $80 at the date of acquisition. Therefore, the subsidiary must pay taxes of $3.50 when the inventory is sold (the reversal of the deferred tax liability).
Consolidation of Unconsolidated Affiliates and Joint Ventures
In some cases, firms have joint ventures or minority-owned affiliates that comprise strategically important components integral to the operations of the firm but that are not consolidated. To get a more complete picture of the economic position and performance of the firm, you may want to assess the firm after consolidating all important minority-owned affiliates. For example, firms frequently work together in joint ventures to carry out their business activities. These companies do not consolidate the financial statements of the joint ventures with their financial statements, but instead use the equity method to account for the joint ventures because they are not majority-owned by the firm.
The procedure to consolidate unconsolidated affiliates and joint ventures follows the consolidated worksheet illustrated earlier. Basically, you eliminate the investment account, add the assets and liabilities of the affiliate or joint venture to the parent’sassets and liabilities, adjust the assets and liabilities for any unamortized differences between the affiliate or joint venture’s book and fair values (if that information is available in the notes to the parent’s financial statements), and recognize the noncontrollinginterest in net assets.
Proportionate consolidation is an alternative to full consolidation. Under proportionate consolidation, the investor’s share of the affiliate’s assets and liabilities appears in separate sections on the asset and liabilities sides of the balance sheet, with the equity investment account eliminated, and no noncontrolling interest is recognized. This alternative is particularly appealing for firms that enter into joint ventures in which ownership of the venture is split equally between two firms. Under U.S. GAAP, firms account for investments in joint ventures using the equity method because these investments fall between minority, active investments and majority, active investments. IFRS permits use of proportionate consolidation for joint ventures, arguing that proportionate consolidation better captures the economics of transactions in which joint control is present
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