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Practical guide to IFRS

Deferred Tax and Business Combinations:
IFRS 3/IAS 12
At a glance
The calculation of deferred tax can be one of the most complex areas of accounting in a
business combination. The acquirer should recognise and measure deferred tax in
accordance with IAS 12.

Contents
At a glance

Deferred tax The basics

Process overview

Step 1

Step 2

Step 3

Step 4

Tax in the financial statements comprises current and deferred tax. Current tax is
based largely on the amounts included in the tax return. These might bear little
resemblance to the amounts in the financial statements. Tax laws and accounting
standards often require that income, expenditure, assets and liabilities are recognised
and measured differently. For example, expenditure accrued in the financial
statements might only be tax deductible when paid in the future. Deferred tax
accounting addresses these differences.

Step 5

10

Outside basis
difference

13

Deferred tax accounting compares the amount recorded in the financial statements
(the book base) with the amount attributable to that asset or liability for tax purposes
(the tax base). The tax base is established by individual territory tax rules. However,
the principles and the process used to recognise and measure deferred tax assets and
deferred tax liabilities in acquisition accounting are the same, no matter where the
acquisition occurs. This guide goes through the process, step by step, of determining
deferred tax in a business combination.
Business combinations could involve the acquisition of different types of enterprise.
Some enterprises (such as limited liability partnerships) do not pay tax directly, and
the profits are taxable in the hands of the investor. These are known as tax
transparent entities. This guide focuses on the acquisitions of corporations that are
taxable entities.

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Process overview
The process to be followed in acquisition accounting is:

Step 1

Transaction

Taxable

Non-taxable

Step 2

Temporary
Differences

Step 3

Tax Benefits

Step 4

Measure &
Recognise
Deferred
Tax

Step 5

Election

Calculate
Goodwill

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Step 1: Identify the type of transaction.

Determine whether the transaction is non-taxable (where the acquirer purchases the
shares of an entity) or taxable (where the acquirer purchases the individual assets and
liabilities). This usually has an impact on the tax base in step 2.
Step 1A: Initial purchase price allocation.
All assets acquired and liabilities assumed should be recognised and measured at the
acquisition date in accordance with IFRS 3. This is done before considering the
deferred tax consequences in step 2 onwards.
Step 2: Calculate the temporary differences on identifiable assets and
liabilities at the date of acquisition.
Identify the tax base of all assets and liabilities recognised in acquisition accounting
and compare this with the book base of those assets and liabilities at the acquisition
date. Determine whether the resulting temporary differences are deductible temporary
differences or taxable temporary differences.
Step 3: Identify any additional tax benefits.
Identify any additional tax attributes that arise from the acquisition (for example, the
acquirees tax loss, tax credit, or other carry-forwards). Determine whether a deferred
tax asset can be recognised.
Step 4: Measure all temporary differences and recognise deferred tax
assets and liabilities.
Measure temporary differences and tax attributes identified in steps 2 and 3, and
recognise deferred tax assets or deferred tax liabilities. [IFRS 3 para 24]. Deferred
tax assets and deferred tax liabilities are measured at the tax rates that are expected to
apply to the period when the asset is realised or the liability is settled.
Step 5: Calculate and recognise goodwill.
Calculate goodwill, including the deferred tax assets and deferred tax liabilities
recognised in step 4, as part of the identifiable net assets at the acquisition date. A
deferred tax liability arising from the initial recognition of goodwill is not recognised. A
deferred tax asset is recognised for excess tax-deductible goodwill, subject to the usual
recognition criteria.

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Step 1: Type of transaction

An acquirer could either buy the share capital of an entity or buy the entitys
identifiable assets and liabilities directly. The structure of the transaction will have an
impact on the tax base of those assets and liabilities.
Taxable transactions (assets and liabilities)
A taxable transaction arises where an acquirer purchases the assets and liabilities
directly. The seller typically pays tax on the sale of the assets. The acquirer typically
obtains tax basis equal to the price paid for the acquired assets and liabilities. Where
the acquisition price exceeds the aggregate fair value of identifiable assets acquired and
liabilities assumed, the excess is often treated as goodwill for tax purposes. The
goodwill might or might not be tax deductible.
Non-taxable transactions (shares)
A non-taxable transaction arises where an acquirer purchases the shares of an entity.
The selling shareholders typically pay tax on any gain on the sale of their shares, and
the acquirer typically obtains tax basis for the cost of the shares. The tax base of the
identifiable assets and liabilities of the acquired entity typically passes over to the
acquirer at pre-acquisition amounts, and no new tax goodwill is created. Any tax
goodwill of the acquiree that arose in a previous acquisition might carry over and will
be considered in determining temporary differences.
Some jurisdictions, such as the US, provide an option to elect to treat the acquisition of
shares as a taxable transaction.

Step 2: Temporary differences

A temporary difference is the difference between the carrying amount of an asset or
liability in the statement of financial position (its book base) and the amount that is
attributable to that asset or liability for tax purposes (its tax base). Tax laws differ by
jurisdiction; so, each acquired entity and each tax jurisdiction should be evaluated
separately to determine the tax base of the acquired assets and assumed liabilities.
Temporary differences typically arise from the following in a business combination:

remeasurement at fair value in accordance with IFRS 3;

recognition of previously unrecognised assets and liabilities; and
manner of recovery of the specific asset or liability.

Remeasurement of fair value in accordance with IFRS 3

IFRS 3 requires almost all of the acquirees identifiable assets and liabilities to be
recognised at their fair value at the acquisition date. The tax base depends on the type
of transaction identified in step 1.
Tax base in a taxable transaction
The tax base in a taxable transaction is likely to be the fair value of the individual assets
and liabilities according to the local tax law. This often means that no temporary
differences arise at the acquisition date, other than those that arise from goodwill.

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Tax base in a non-taxable transaction

The tax base of individual assets and liabilities in a non-taxable transaction is likely to
stay the same as the acquirees pre-acquisition tax base. Remeasurement to acquisition
date fair value will create an additional temporary difference.
Example 1
Company X acquires Company Y. Company Y has an asset recorded in its financial
statements with the following values:

Carrying amount CU120

Tax base CU80

Fair value at acquisition CU150

Question: How would the deferred taxes related to that asset be recorded in a taxable
and non-taxable business combination?
Answer:
The asset would be recorded at its fair value of CU150 on the acquisition date (book
base). The old tax base is likely to carry over (CU80) in a non-taxable transaction. The
tax base is likely to be the fair value (CU150) in a taxable transaction.
This is illustrated in the table:
Non-Taxable Transaction
Book Base

Tax Base

Temporary Difference

150

80

70

150

Taxable Transaction
150

Previously unrecognised assets and liabilities (non-taxable transaction)

An acquirer might also recognise assets and liabilities that were not recognised by the
acquiree in its financial statements prior to the acquisition date. This can result in the
recognition of intangible assets in a business combination, such as a brand name, inprocess R&D or customer relationships. [IFRS 3 para 13]. Likewise, contingent
liabilities will be recognised in a business combination.
The intangible is recognised at fair value at the acquisition date (the book base). No tax
deduction is typically allowed through amortisation or on sale of the asset; this is
because the acquiree did not purchase the asset. So the tax base is nil. This results in a
temporary difference that should be recognised in acquisition accounting.
The temporary difference will decrease over time if the intangible is amortised in the
financial statements. The temporary difference will remain until the intangible is
impaired, or until it is sold if the intangible has an indefinite life.

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Example 2
A customer relationship is identified on the acquisition date and recognised at fair
value of CU1,300. The tax basis of the intangible asset is zero, because no deduction is
allowed in the tax jurisdiction. The tax rate is 40%.
Question: What is the deferred tax effect of recognising the intangible asset?
Answer:
The customer relationship creates an additional temporary difference equal to the fair
value of the intangible at the acquisition date. The following entry is recorded at the
acquisition date:
Dr

Intangible asset

CU1,300

Cr

Deferred tax liability

CU250

Cr

Goodwill

CU780

The temporary difference deferred tax liability should be adjusted in subsequent

periods for amortisation if the intangible has a definite useful life.
The same principle applies to the recognition of contingent liabilities: a contingent
liability is recognised at fair value at the acquisition date in accordance with IFRS 3.
Contingent liabilities are not generally recognised for tax purposes until the amounts
are fixed and reasonably determinable or, in some jurisdictions, until they are paid.
These items have no tax basis on the acquisition date, and the difference between the
fair value recognised in the financial statements and the tax base of nil results in a
temporary difference and a deferred tax asset in acquisition accounting.
Example 3
Assume a contingent liability is recorded at fair value of CU1,000 on the date of
acquisition in a non-taxable business combination. The tax basis of the contingent
liability is zero. When the liability is settled, the entity will receive a tax deduction for
the amount paid. The tax rate is 40%.
Question: What is the deferred tax effect of recognising the contingent liability?
Answer:
The contingent liability creates a temporary difference at the acquisition date, because
it has a zero tax basis and will result in a tax deduction when it is settled. The following
entry is recorded at the acquisition date:
Dr

Deferred tax asset

CU400

Dr

Goodwill

CU600

Cr

Contingent liability

CU1,000

The temporary difference deferred tax asset should be adjusted in subsequent periods
as the amount of the contingent liability changes.

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Previously unrecognised assets and liabilities (taxable transaction)

The accounting for contingent liabilities in a taxable transaction is more complicated,
and depends on whether and how settlement of the liability will be deductible under
the local tax rules.
There are two approaches to accounting for this temporary difference:
1.

The tax basis of the goodwill is adjusted by the amount recorded for the
contingency where settlement of the contingent liability would result in taxdeductible goodwill.

2. The contingency is treated as a separate tax-deductible item if it will be deducted

separately when paid. A deferred tax asset is recorded in acquisition accounting,
because the liability (when settled) will result in a future tax deduction.
Manner of recovery
The way in which an asset is going to be used can affect its tax base. The carrying
amount of an asset might be recovered through use, sale, or both. The tax
consequences of using an asset are sometimes different from the consequences of
selling the asset, and this might directly affect the tax that would be payable in the
future. Assets might sometimes be revalued or indexed to inflation for tax purposes
only if the asset is sold (that is, the tax basis is increased for the purpose of determining
capital gain income but not regular income). The expected manner of recovery is
considered to determine the future tax consequences and corresponding deferred taxes
in acquisition accounting.
Example 4
An item of plant, property and equipment is recorded at fair value of CU10m at the
acquisition date. It will be depreciated over 10 years. Accounting depreciation is not
deductible for tax purposes. If the plant is used in the business for its full 10-year life, it
will be fully consumed and will have to be scrapped. No tax deductions will be available
for scrapping the asset. If the asset is sold, the cost of the asset of CU8m is deductible
on sale. The tax rate is 40% and is not affected by the manner of recovery.
Question: What is the impact of the manner of recovery on the tax base of the asset?
Answer:
Management needs to consider how it expects to recover the assets carrying amount to
determine the tax base. The tax base will be zero if the asset is to be used in the
business. A temporary difference of CU10m arises and a deferred tax liability of CU4m
is recognised. The deferred tax liability is reduced as the asset is depreciated.
The tax base will be CU8m if the asset is to be sold. A temporary difference of CU2m
arises and a deferred tax liability of CU0.8m is recognised. The deferred tax liability is
released when the asset is sold.

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Step 3: Tax benefits?

A business combination can result in the recognition of additional tax attributes that
could not be recognised by the acquiree before the acquisition. The acquiree might
have tax losses, tax credits or other carry-forwards that can be used against future
taxable profits of the expanded group.
A deferred tax asset is recorded only if it is probable that sufficient taxable profit will
be available against which deductible temporary differences or other carry-forwards
can be utilised. An acquiree might have tax losses where no deferred tax asset had been
recognised because future profits were not probable. However, those losses might
become available for use by other entities within the group following the acquisition
allowing the recognition criteria to be met.
Sources of taxable profit
It is necessary to consider all available evidence to determine whether a deferred tax
asset is recognised at the date of acquisition.
There are a number of sources of future taxable income that might arise from a
business combination:

the acquirer has sufficient taxable temporary differences that will generate
taxable income;
the acquiree has sufficient taxable temporary differences arising from the
recognition of assets at fair value that will generate taxable income;
the acquirer anticipates that there might be sufficient other income (this could
include profits elsewhere in the group, if these can be offset by the acquirees
losses under the relevant tax laws); or
tax planning opportunities might reduce future expenses or create additional
taxable income.

The recoverability of deferred tax assets is reassessed at each reporting date.

Subsequent changes in deferred tax assets are not recognised in
acquisition accounting.
What about the acquirers benefits?
The acquirer might also have unused tax losses for which a deferred tax asset can be
recognised as a result of the business combination. This is a transaction of the acquirer,
and so it is recognised outside acquisition accounting.

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Step 4: Measure and recognise

Steps 2 and 3 identify the temporary differences. These are measured, and the resulting
deferred tax assets and liabilities are recognised in step 4. There are two types of
temporary difference: a temporary taxable difference is a difference that will give rise
to future taxable income, and therefore a deferred tax liability; and a deductible
temporary difference gives rise to a future tax deduction, and therefore a deferred
tax asset.
Deferred tax assets and deferred tax liabilities are recognised for substantially all
temporary differences and acquired tax loss and credit carry-forwards, subject to the
usual recognition criteria.
There are two exceptions:
1. temporary differences for goodwill that is not tax deductible, and
2. the difference between the carrying amount of the subsidiarys net assets in the
consolidated financial statements and the parents tax basis in the shares of the
subsidiary (see the section on outside basis difference below). [IAS 12 paras 19,
39; IFRS 3 paras 24, 25].
What tax rate should be used?
All temporary differences identified are measured using the tax rates that are expected
to apply in the period when the asset will be realised or the liability settled.
An acquirer should consider the effects of the business combination to determine the
applicable tax rate for each jurisdiction (and, in some cases, for individual
temporary differences).
The applicable rate is determined based on enacted or substantially enacted tax rates,
even if the parties considered apparent or expected changes in tax rates in their
negotiations. The applicable tax rate(s) used to measure deferred taxes should be
determined based on the relevant rate(s) in the jurisdictions where the acquired assets
are recovered and the assumed liabilities are settled. This is usually the
acquirees rates.
The manner of recovery (see step 2 for more detail) of an asset can also affect the tax
rate (for example, some jurisdictions will have one rate for capital gains and a different
rate for income tax). The manner of recovery or settlement of each of the assets and
liabilities is identified before the applicable rate is determined.

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Step 5: Calculate goodwill

Deferred tax assets and deferred tax liabilities recognised in step 4 form part of the
total identifiable net assets of the acquiree used to calculate goodwill.
Example 5
On 1 January 20X5, entity H acquired all the share capital of entity S for CU1,500,000.
The fair values of the identifiable assets and liabilities of entity S at the date of
acquisition are set out below, together with their tax bases in entity S's tax
jurisdictions. Any goodwill arising on the acquisition is not deductible for tax purposes.
The tax rates in entity H's and entity S's tax jurisdictions are 30% and 40%
respectively.
Net assets acquired

Book Base
(FV)

Tax
Base

Temporary
Difference

Land and buildings

700

500

200

Property, plant and equipment

270

200

70

80

100

(20)

Accounts receivable

150

150

Cash

130

130

Total Assets

1,330

1,080

250

Accounts payable

(160)

(160)

Retirement benefit obligations

(100)

Net assets before deferred tax liability

1,070

Inventory

100
920

150

Question: What amount of deferred tax and goodwill is recorded on acquisition?

Answer:
A taxable temporary difference arises of CU150, which is the difference between the
fair value (CU1,070) of the assets and liabilities acquired and their tax base (CU920).
This results in the recognition of a net deferred tax liability on acquisition of entity S of
CU60 (CU150 @ 40%)
The fair value of the identifiable assets and liabilities at the acquisition date is now
CU1,010 (CU1,070 CU60), resulting in goodwill of CU490:
Purchase consideration
Fair values of entity S's identifiable assets and liabilities (1070-60)
Goodwill arising on acquisition

1,500
(1,010)
490

The deferred tax on other temporary differences arising on acquisition is provided at

40% (not 30%), because taxes will be payable or recoverable in entity S's tax
jurisdictions when the temporary differences are reversed. No deferred tax is
recognised on the goodwill, even though it is not tax deductible.

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Goodwill is sometimes tax deductible, usually through an annual amortisation (or

equivalent) deduction or a deduction when the associated business is subsequently
sold, reducing the taxable gain on sale.
A temporary difference could arise on tax-deductible goodwill. This usually
arises from:

the tax and accounting rules differing on the amount of consideration;

different valuations of assets and liabilities; or
the amounts being allocated differently (impairment vs amortisation).

The deductibility of goodwill

A temporary difference could arise initially (that is, at acquisition) or subsequently. IAS
12 sets out the circumstances in which temporary differences arising from goodwill can
be recognised. To help with this, goodwill is split in two components (components 1
and 2) under US GAAP. The same principle is applied under IFRS, although there is no
specific guidance. The concept of component 1 and component 2 goodwill can be
helpful when calculating the deferred tax impact of goodwill. Component 1 is the
element of book base and the element of the tax base that are equal. An excess that
leads to a temporary difference is called component 2. Component 2 arises from either
the book base or the tax value being higher. This is illustrated in the following diagram:

Initial recognition
The initial recognition of a temporary difference depends on whether component 2
goodwill arises from the book value or the tax value.
A temporary taxable difference arises if the book value is higher than the tax base. IAS
12 does not allow a deferred tax liability to be recognised on the initial recognition of
goodwill. This is because a deferred tax liability would reduce the fair value of
identifiable assets and increase book goodwill. The overall impact is to gross up
goodwill, which does not provide useful information.
A deductible temporary difference arises if the tax base is higher than the book base. A
deferred tax asset is recognised if the recognition criteria are met (that is, realisation
will depend on available future taxable profit).
A deferred tax asset complicates the calculation of goodwill. The additional asset
increases the net assets acquired, which reduces the book base of goodwill in the
financial statements, leading to a larger temporary difference. To solve this issue, an
iterative formula is used to determine goodwill and the deferred tax asset:
(tax rate/(1 tax rate)) preliminary temporary difference (PTD) = deferred tax asset
This formula sometimes needs to be adjusted, and it cannot always be used in more
complex business combinations (for example, where there is not a single tax rate or
there is a gain in bargain purchase). Where this is the case, we would advise
consultation.

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Example 6
A taxable acquisition results in initial book goodwill of CU450. A separate
determination for taxes results in tax-deductible goodwill of CU600. The difference
between book and tax goodwill is CU150. Assume a tax rate of 40%.
Question: How is the deferred tax asset calculated?
Answer:
Without the iterative formula, the deferred tax asset would be calculated as:
(CU600 CU450) 40% = CU60
The recognition of an additional asset of CU60 would reduce book goodwill to CU390.
There is now a bigger temporary difference of (CU600 CU390) = CU210. This
process continues; so, to simplify the calculation, we use the following formula:
(tax Rate/(1 tax Rate)) x preliminary temporary difference (PTD) = deferred tax asset
(40%/(1 40%)) CU150 = deferred tax asset of CU100
The acquirer records a deferred tax asset for CU100, with a corresponding decrease in
book goodwill. Goodwill for financial reporting purposes is CU350, and a deferred tax
asset of CU100 is recorded. The resulting deferred tax asset reflects the temporary
difference related to goodwill, as illustrated below:
(Tax goodwill book goodwill) 40% = deferred tax asset
(CU600 CU350) 40% = CU100

Subsequent treatment
No deferred tax liability is recorded initially where the carrying amount of goodwill
exceeds the tax base. A deferred tax liability is recognised subsequently if component 1
goodwill changes. No deferred tax liability is recognised for a change in component 2
goodwill (excess).
Example 7
The carrying amount of goodwill is initially CU100 with a tax base of zero. At the end of
year 1, the goodwill is impaired by CU10.
Question: What is the deferred tax effect of the initial and subsequent measurement
of goodwill?
Answer:
The initial taxable temporary difference is CU20, but this cannot be recognised.
The tax base of goodwill has reduced to CU64 (CU80 80%) by the end of year 1, but
the carrying amount remains unchanged. The reduction of CU16 in component 1
goodwill is measured and recognised as a deferred tax liability.

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Example 8
The carrying amount of goodwill is initially CU100, with a tax base of CU80. A
deduction is allowed for tax purposes at 20% per year. No impairment has occurred in
year 1.
Question: What is the deferred tax effect of the initial and subsequent measurement of
goodwill?
Answer:
The initial taxable temporary difference is CU20, but this cannot be recognised.
The tax base of goodwill has reduced to CU64 (CU80 80%) by the end of year 1, but
the carrying amount remains unchanged. The reduction of CU16 in component 1
goodwill is measured and recognised as a deferred tax liability.
Calculating goodwill was the last step in the process for acquisition accounting. The
purchase price allocation can now be finalised.
Deferred tax impacts other areas of group accounting. The main impact is
discussed below.

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Outside basis difference

This practical guide has focused on looking inside the entity, comparing the book base
and the tax base of individual assets and liabilities (the inside basis differences).
However, the parents investment in the subsidiary can also give rise to a temporary
difference and deferred tax accounting in a non-taxable transaction; this is called an
outside basis difference. It arises when the carrying amount of the subsidiary in the
consolidated financial statements is different from the tax base, which often relates to
the cost of the investment at the date of acquisition.
Example 9
Entity X acquires 100% of entity Y for CU1,000, which is the tax base of the
investment. The fair value of the identifiable assets and liabilities of entity Y at the
acquisition date were CU800, giving rise to goodwill of CU200.
Question: What is the outside basis difference on the acquisition date?
Answer:
The carrying amount of the investment in entity Y is CU1,000, made up of goodwill of
CU200 and the fair value of the net assets of CU800.
The tax base is the consideration for the investment of CU1,000.
There is no outside basis difference on the acquisition date.
There is often no temporary difference on an outside basis at the acquisition date.
However, some complexities (including contingent consideration and acquisition
costs) can result in the carrying amount being different from the tax base. We would
advise consultation if either of these items arises.
Subsequent treatment
The carrying amount of the investment will change after the acquisition date; for
example, where:

the investee earns profits post acquisition;

the exchange rate changes on a foreign subsidiary; or
the carrying amount of the investment is impaired.

These changes will alter the book basis of the investment, but not the tax basis, and
they could give rise to a temporary difference. IAS 12 provides an exception for
recognising the deferred tax arising on the outside basis difference. The exception is
required if the parent controls the timing of the reversal of the temporary difference,
and it is probable that the temporary difference will not reverse in the
foreseeable future.
This exception applies to all subsidiaries, branches, associates, and interests in joint
ventures under IFRS if the criteria are met.
Subsidiary
The ability to control the reversal is always assumed if the investment is a subsidiary,
because a parentsubsidiary relationship is one of control. Management should then
determine if the subsidiarys profits will be distributed or if the subsidiary will be sold
in the foreseeable future. This will most likely depend on whether there is an intention
either to declare dividends or to sell the subsidiary. Management often concludes that
the subsidiary will continue to re-invest its earnings rather than remit them, but this is
not always the case.

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Associate
The acquirer has significant influence, but not control, over an associate, and so the
control over timing of the reversal cannot be assumed. The acquirer recognises a
deferred tax liability on the outside basis difference, unless there is an enforceable
agreement that the associates profits will not be distributed in the foreseeable future.
Joint arrangement
The terms of the contractual arrangement between venturers over the distribution of
profits will determine whether deferred tax should be recognised for the temporary
difference arising in connection with a joint arrangement.
Deferred tax asset
The outside tax basis of an investment might exceed the book basis. IAS 12 prohibits
the recognition of a deferred tax asset for an investment in a subsidiary, branch,
associate or joint venture unless the temporary difference will reverse in the
foreseeable future and taxable profit will be available against which the temporary
difference can be utilised.
Where can I find more information?
For more information about deferred tax in business combinations, please also
refer to:

Chapter 13 of the IFRS Manual of Accounting;

Chapter 5 of the Global Guide to Business Combinations; and

US Guide to Accounting for Income Taxes.

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