In many mergers and acquisitions (M&A) transactions, the target company has one set of financial information for “book accounting” purposes (or book basis) and another for “tax accounting” purposes (or tax basis). At times, the two sets of books exhibit temporary differences that result in what are called deferred income taxes. In this article, I will explain the sources of deferred income taxes, perform some deferred income tax calculations, and explain how they are relevant to M&A valuations / transactions.
Sources of Deferred Income Taxes
As I mentioned above, deferred taxes arise when there are differences in the way a company reports its financials for book versus tax purposes. Book accounting most often reflects U.S. Generally Accepted Accounting Principles (GAAP) while tax accounting conforms to the Internal Revenue Code (IRC). GAAP follows full accrual accounting while the IRC follows modified cash accounting. The different accounting rules are typically most relevant for items such as:
- Depreciation of long-term assets
- Certain accrued and deferred revenues
- Certain accrued and deferred expenses
Under GAAP reporting, a company applies GAAP accounting rules to its economic transactions. At the same time, the company applies IRC accounting rules to those same economic transactions for IRC reporting. If the rules are different (and they often are), then the company will report differences in the calculation of “income” under GAAP compared to the IRC. As you can imagine, some companies may have hundreds of economic transactions that are handled differently under GAAP and the IRC. Furthermore, these differences may persist or change over several years. Keeping track of all these differences can be quite complex.
Importantly, like any other revenue or expense, GAAP reports income tax expense following GAAP rules while the IRC reports income taxes payable following IRC rules. So each difference in the calculation of income has an accompanying difference in the calculation of income taxes. Ultimately, each temporary difference gives rise to a deferred tax item and is categorized as a deferred tax liability (DTL) or deferred tax asset (DTA).
As a practical matter, most companies aggregate the many DTAs and DTLs into one “net” DTL (most often) or DTA (rarely). The net DTL or net DTA allows the company to reconcile income tax expense (under U.S. GAAP) with income taxes paid (under the IRC). A net DTL captures income tax expense recorded in the current period following U.S. GAAP that will be paid under the IRC in a future period while a net DTA captures income taxes paid in the current period under the IRC that will be recorded as an income tax expense in a future period under U.S. GAAP.
Deferred Income Tax Calculation
There are several ways to approach deferred income taxes, but I have found that focusing on the balance sheet is critical to fully understanding them, so I will primarily adopt this focus as we walk through an example calculation. There are two factors that buyers and sellers should keep in mind when dealing with deferred income taxes.
- Most buyers and sellers focus on the income statement for income taxes (for good reason), but the balance sheet communicates the most complete information about the sources of deferred taxes.
- Identifying differences in the “net book value” of assets and liabilities under GAAP and the IRC is the key to understanding the implications of DTAs and DTLs.
The most common source of deferred taxes is depreciation of long-term assets. Typically, the IRS allows for accelerated depreciation of fixed assets while most companies use straight-line depreciation under U.S. GAAP. Accelerated depreciation allows companies to defer payment of income taxes since the higher depreciation expense reduces taxable income under the IRC. Most companies prefer to defer expenses under U.S. GAAP and straight-line depreciation allows them to do so compared to an accelerated depreciation method.
Example: A construction company purchases a fleet of trucks for $500,000 on January 1, 2020. The company depreciates the fleet under the IRC in the amounts of $250,000 (2020), $150,000 (2021), and $100,000 (2022). The company uses five-year straight-line depreciation under U.S. GAAP (or $100,000 per year). For simplicity’s sake, we’ll assume that the company has $1,000,000 of pre-tax (GAAP) income each year and that the depreciation of the fleet is the only difference between the book basis and tax basis of accounting.
The table below illustrates the balance sheet treatment of the fleet under the two systems and also depicts the difference in income and income taxes attributable to the difference.
|Net Book Value (GAAP)||$400,000||$300,000||$200,000||$100,000||$0|
|Net Book Value (IRC)||$250,000||$100,000||$0||$0||$0|
|Difference in NBV||$150,000||$200,000||$200,000||$100,000||$0|
|x Tax Rate||x 21%||x 21%||x 21%||x 21%||x 21%|
|Deferred Tax Liability||$31,500||$42,000||$42,000||$21,000||$0|
|Pretax (GAAP) Income||$1,000,000||$1,000,000||$1,000,000||$1,000,000||$1,000,000|
|Difference in Depreciation||($150,000)||($50,000)||$0||+$100,000||+$100,000|
|Taxable (IRC) Income||$850,000||$950,000||$1,000,000||$1,100,000||$1,100,000|
|Income Tax Expense (GAAP)||$210,000||$210,000||$210,000||$210,000||$210,000|
|Income Taxes Payable (IRC)||$178,500||$199,500||$210,000||$231,000||$231,000|
In the example, the company is able to defer $31,500 in 2020 taxes and another $10,500 in 2021 through accelerated depreciation under the IRC. The deferred tax liability balance on 12/31/2021 accumulates the deferred taxes for these two years for a total of $42,000 in deferred taxes. Eventually, the deferred tax liability “unwinds” in 2023 and 2024 because the company cannot permanently defer taxes through accelerated depreciation. In other words, over the five years, the total income tax expense and income taxes paid are equal GAAP and the IRC, but the expense is recorded earlier than the payments.
This example demonstrates just one difference, but a company likely has many differences that change over time and oftentimes will (partially) offset each other.
Deferred Income Taxes in M&A
For a company that continues to operate under existing ownership, deferred taxes are an integral part of their tax-planning activities. However, an M&A transaction can short-circuit the normal process of managing DTLs (or DTAs) and may create an immediate tax consequence for the seller or buyer.
In an asset sale, any “net” DTL will create an additional tax burden for the seller because the DTL will immediately unwind in the year of the sale. Let’s say that the company in the example above was sold on 12/31/2021. Let’s also say that in the sale, the transaction assigns a value to the fleet of trucks equal to the NBV under U.S. GAAP. The seller will not have a gain under U.S. GAAP, but under the IRC, the seller will have a “gain on sale” equal to $200,000. This gain will result in an additional tax payment of $42,000 for the 2021 tax year – the DTL unwinds immediately.
The issue is a little more complicated in a stock sale since assets (and liabilities) do not transfer to a new entity. Informed buyers must understand DTLs and DTAs and how the company had managed them in the past. Most DTLs and DTAs can continue to be managed and should not impact the negotiated terms of the deal, but others may not. As an example from a recent M&A transaction, the sellers purchased their personal vehicles from the company immediately before the deal closed. Their vehicles had associated DTLs and, therefore, the DTLs immediately unwound creating an additional tax burden for the company in the year of the sale.
Summary of Implications
In this article, I briefly introduce the role of deferred taxes in M&A transactions. While I use a very simplistic example to illustrate how deferred taxes may impact a transaction, most transactions involve much more complex issues. Because of their complexity, it is critical that buyers and sellers consult a professional tax accountant. It would be helpful to consult a tax accountant with M&A experience since experience is the best teacher in addressing these issues. At a minimum, ensure that you utilize a professional M&A advisor who understands the potential tax implications from an impending transaction. While most M&A advisors cannot (and should not) offer tax advice, a competent advisor should be able to articulate the relevant issues that need to be addressed with your CPA.