Robert Bushman Complex Deals Class 8 Implications of a deal’s tax structure for financial reporting Accounting for financial distress; an introduction

Implications of a deals tax structure for financial reporting Financial reporting rules and tax laws are independent, which leads to two distinct sets of financial statements. Financial Reporting: Under Acquisition Accounting, the acquirer always writes-up/(down) the book value of the target’s net assets to the purchase price. Tax Reporting: Whether or not the Net Inside Basis (NIBT) of the target’s net assets is also stepped-up to the purchase price depends on the tax structure of the deal. Differences between these two balance sheets reflect important economic information.

Financial Reporting Implications: Carry-over Tax Basis For each identifiable asset and liability, Acquisition Accounting requires the acquirer to record a deferred tax liability (DTL) as part of the purchase price allocation on the deal closing date computed as: No DTL recognized for Goodwill because it is considered a permanent difference for deals with a carry-over tax basis (that is, it does not exist for tax purposes; tax basis=0) Purchase Price Financial Reporting Fair Value of Net Identifiable Assets (FVNIAT) Goodwill Tax Reporting Net Inside Basis (NIBT) Temporary Difference Permanent “Carry-over” old NIBT DTL = (FVNIAT – NIBT) × Acquirer's tax rate NOTE: The deferred tax items reverse through time after the deal closes as the step-ups are amortized and/or depreciated on the books or when the net assets are sold.

For Which Type of Deal is Goodwill Tax Deductible? Taxable stock acquisition of a subsidiary with a Section 338(h)(10) election. Taxable stock acquisition of a C Corporation without a Section 338 election Taxable asset acquisition. YES NO Taxable stock acquisition of a freestanding C Corporation with a Section 338(g) election. All tax-free acquisitions Rarely done

Timing Differences Between Financial Reporting and Tax => Deferred Tax Liabilities and Assets A current tax liability or asset is recognized for taxes payable or refundable for the current year Deferred tax asset or liability is recognized for the future tax effects attributable to i) temporary differences between book values and tax values and ii) NOLs and other tax credits Permanent differences do not result in deferred tax assets and liabilities Temporary differences result from different methods for accounting and tax purposes. These are timing differences that will reverse over time. Example include differences between depreciation methods for financial statement and for tax purposes. Permanent differences will never be reported in the tax return and may include interest on municipal bonds, and impairment write downs of goodwill when an acquirer is not able to step up the tax basis of assets in an acquisition.

Book vs. Tax Difference and DTL : Example Financial Reporting 2014 2015 2016 Total Revenues $130,000 $130,000 $130,000 $390,000 Expenses (Straight line depreciation) 30,000 30,000 30,000 90,000 Pretax financial income $100,000 $100,000 $100,000 $300,000 Income tax expense (40%) $40,000 $40,000 $40,000 $120,000 Tax Reporting 2014 2015 2016 Total Revenues $130,000 $130,000 $130,000 $390,000 Expenses (accelerated depreciation) 40,000 30,000 20,000 90,000 Pretax taxable income $90,000 $100,000 $110,000 $300,000 Income tax payable (40%) $36,000 $40,000 $44,000 $120,000 Note difference between book and tax depreciation in 2014 and 2016

Book vs. Tax Difference and DTL Comparison & Journal Entries 2014 2015 2016 Total Income tax expense (financial reports) $40,000 $40,000 $40,000 $120,000 Income tax payable (tax return) 36,000 40,000 44,000 120,000 Difference $4,000 $0 $(4,000) $0 Income Tax Expense 40,000 Taxes Payable 36,000 Deferred Tax Liability 4,000 Income Tax Expense 40,000 Taxes Payable 40,000 Income Tax Expense 40,000 Deferred Tax Liability 4,000 Taxes Payable 44,000

Balance Sheet Approach to and DTL Book Value Tax Basis Difference DTL= Difference*Tax Rate 1/1/2014 $90,000 $90,000 $0 $0 Depreciation <30,000> <40,000> 12/31/2014 60,000 50,000 $10,000 $4,000 - Depreciation <30,000> <30,000> 12/31/2015 30,000 20,000 $10,000 $4,000 Depreciation <30,000> <20,000> 12/31/2016 0 0 $0 $0

Acquires on Jan. 26, 2009 => Carry-over tax basis! Pfizer footnote: (Deferred Tax Liability) Pfizer footnote: The increase in the net deferred tax liability position in 2009 compared to 2008 was primarily due to the noncurrent deferred tax liabilities related to identifiable intangible assets established in connection with our acquisition of Wyeth 9

DTL = (FVNIAT – NIBT) × Acquirer's tax rate What is the interpretation of the acquisition date DTL? DTL = (FVNIAT – NIBT) × Acquirer's tax rate Actual tax shield available to the acquirer = NIBT (e.g., future deductible depreciation) Future income offset in financial statements = FVINAT (e.g., future book depreciation expense) FVNIAT > NIBT Book expenses (based on FVINA) will be > Tax deductions (based on NIB) Pre-tax book income < Taxable Income Tax Expense < Actual taxes owed The DTL recorded at acquisition is a warning that future Tax Expense < Actual taxes owed

Financial Reporting Implications: Stepped-Up Basis For each identifiable asset and liability in a deal with a stepped-up tax basis (e.g., 338 election), the acquirer’s tax basis is set equal to the fair value. Therefore: No DTL is recognized in a deal structured with a stepped-up basis. Note also that the tax basis of Goodwill = its financial reporting amount! Purchase Price Financial Reporting Fair Value of Net Identifiable Assets (FVNIAT) Goodwill Tax Reporting Net Inside Basis (NIBT) Step-up (down) of Net Identifiable Assets Goodwill DTL = (FVNIAT – FVNIAT) × Acquirer's tax rate = 0

338(h)(10) Vignettes Flowers Foods Inc: On July 21, 2012, two wholly owned subsidiaries of the company acquired Lepage Bakeries, Inc. (“Lepage”) and certain affiliated companies. The aggregate purchase price was $383.0 million. An additional $18.4 million was paid to the shareholders of Lepage at closing in connection with certain incremental tax liabilities that will be incurred by these shareholders in conjunction with the joint election under Section 338(h)(10) of the Internal Revenue Code. July 15, 2012: Thermo Fisher Scientific Inc. (NYSE: TMO), the world leader in serving science, today announced that it has signed a definitive agreement to acquire One Lambda, the leader in transplant diagnostics, for $925 million in cash. Thermo Fisher and One Lambda expect to make an election under section 338(h)(10) of the Internal Revenue Code that will increase Thermo Fisher’s tax basis in the acquired assets. This election will result in annual cash tax savings of approximately $19 million over 15 years, yielding a net present value benefit of approximately $190 million for Thermo Fisher.

Acquisition Accounting with Tax Implications: Example Deal Structure: On Jan. 1, 2010 A purchases 100% of T. T’s Stand-alone Financial Reporting (FR) and Tax Balance Sheets: FR Tax Cash $ 1,000 $ 1,000 PP&E, net 8,000 7,000 Total Assets $ 9,000 $ 8,000 Long-term debt $ 3,600 $ 3,600 Deferred Tax Liability (DTL) 400 – Equity 5,000 4,400 Total Liabilities & Equity $ 9,000 $ 8,000

Additional Information and Assumptions On the deal closing date, the fair value of T’s PP&E was assessed to $10,000 Assume PP&E is depreciated straight-line over 20 years for financial reporting purposes and straight-line over 10 years for tax purposes. On the deal closing date, T has unrecognized identifiable intangible assets of $1,500 amortized straight-line over 10 years for book (GAAP) purposes. How long is it amortized for tax purposes in the U.S.? A’s and T’s statutory tax rates = 40%.

Scenario 1: Taxable Asset Acquisition A structures the deal as a Taxable Asset Acquisition (or a Taxable Stock Acquisition with 338 Election) for tax purposes and pays $13,733 in cash to T. Purchase Price Allocation (Financial Reporting): Purchase Price of Equity $ 13,733 (given above) – BVNAT: (5,000) (from book balance sheet) = Unamortized Differential: $ 8,733 (1) PP&E write-up: $ 2,000 = $10,000 – $8,000 (2) Intangible assets write-up: 1,500 (given) (3) write-off existing Net DTL of T: 400 (always write-off existing DTL) (4) less Net DTL: (0) (Tax basis=FVINA due to 338) – Net Asset Write-ups: (3,900) = (1) + (2) + (3) +(4) = Goodwill 4,833 (test for impairment)

Scenario 1: Taxable Asset Acquisition cont’d Purchase Price Allocation (PPA) – Tax purposes: Purchase Price of Equity $ 13,733 (given on previous slide) – NIBT: (4,400) (from tax balance sheet) = Taxable Gain: $ 9,333 (1) PP&E step-up: $ 3,000 = $10,000 – $7,000 (2) Intangible assets step-up: 1,500 (given) – Net Asset Step-ups: (4,500) = (1) + (2) = Goodwill $ 4,833 (amortize over 15 years) A’s Net Inside Basis in net assets acquired: $ 13,733 = Purchase Price Section 197 deductible intangibles created: 6,333 = $1,500 + $4,833 Taxes paid by T for asset sale 3,733 = $9,333 × 40% (or paid by A if 338(g) or seller corp. if 338(h)(10))

DTL = (Tax Depreciation – Book Depreciation) × tax rate Scenario 1: Taxable Asset Acquisition - DTL in post-acquisition periods On Dec. 31, 2010, a deferred tax liability due to timing differences arising from the different asset lives used for financial reporting and tax purposes: Journal entry made on 12/31/10 to capture effects of DTL created: Income Tax Expense $ X Taxes Paid/Taxes Payable $ (X – 308.9) DTL 308.9 DTL = (Tax Depreciation – Book Depreciation) × tax rate

Purchase Price Allocation (PPA) – GAAP purposes: Scenario 2: Taxable Stock Acquisition with carry-over tax basis (i.e., no 338 election) A structures the deal as a taxable stock acquisition or for tax purposes and pays $13,733 in cash to T ’s shareholders. Purchase Price Allocation (PPA) – GAAP purposes: Purchase Price of Equity $ 13,733 (given above) – BVNAT: (5,000) (from book balance sheet) = Unamortized Differential: $ 8,733 (1) PP&E write-up: $ 2,000 = $10,000 – $8,000 (2) Intangible assets write-up: 1,500 (given) (3) less Net DTL: (1,800) = ($10,000 – $7,000) × 40% + (1,500 – $0) × 40% (4) write-off existing Net DTL of T: 400 (always write-off existing DTL) – Net Asset Step-ups: (2,100) = (1) + (2) + (3) +(4) = Goodwill 6,633 (test for impairment)

Scenario 2: Taxable Stock Acquisition with carry-over tax basis (i. e Scenario 2: Taxable Stock Acquisition with carry-over tax basis (i.e., no 338 election) Because A structured deal as a taxable stock acquisition with no 338 election: For tax purposes, the basis of A in T ’s assets (net inside basis) is the carry- over basis equal to $4,400. No Section 197 Intangible assets are created in the deal (Goodwill and intangible assets have a zero tax basis) A’s Outside Basis in T’s stock is the Purchase Price = $13,733.

Scenario 2: Taxable Stock Acquisition with carry-over tax basis (i. e Scenario 2: Taxable Stock Acquisition with carry-over tax basis (i.e., no 338 election) Incremental depreciation/amortization taken on asset write-ups for book purposes, but not for tax purposes => Book expense incrementally larger than tax deductions by $300 (150+150) => Book NI < Taxable Income Taxes Owed - Tax Expense = Taxable Income*.40 – Book NI*.40 = (Taxable Income-Book NI)*.40 = ($150 + $150) * .40 = $120 Assume Tax Expense = $Y. Then tax journal is: Income Tax Expense $ Y DTL 120 Taxes Paid/Taxes Payable $ 120 + Y => Acquisition-related DTL of $1,800 gradually reverses at $120/year post-acquisition Incremental book depreciation of PPE = $3,000/20 yrs = $150 per year Incremental book amortization of intangibles = $1,500/10 yrs = $150 per year Incremental tax depreciation/amortization = $0

Acquires on Jan. 26, 2009 52.5 Bn Carry-over tax basis! (Deferred Tax Liability) Because Pfizer gets carry-over basis, the $52.5B of Intangibles will provide no future tax shield. A large deferred tax liability is set up to capture this. Assume tax rate = .27 => DTL = $52.5*.27 = $14.1 B 19.8 – 5.7 = $14.1B 21

Acquires on Jan. 26, 2009