GAAP and IFRS

Balancing Act

FAS 142 has a few tax-planning implications for the balance sheet.
Lisa YoonOctober 16, 2001

Where new financial accounting rules go, are a spate of complex new tax issues sure to follow?

Under FAS 142, for the most part, “the tax planning [does] not really change at all,” says Frank O’Connell, tax partner at accounting firm Crowe Chizek and Co. LLP. The tax code’s counterpart to FAS 142, Goodwill and Other Intangible Assets, was established in 1993 and continues to operate largely unaffected by the new rule. Barring certain effects on the balance sheet, “the tax system operates on its own,” says Robert Willens, tax and accounting analyst at Lehman Brothers Holdings Group Inc. “Intangible assets are for the most part amortized over 15 years, period, end of story.”

As for the balance sheet, explains Willens, “There’s sort of a bridge between the tax and accounting treatment of an item, and it’s the deferred tax liability or asset account.” In a deal that’s structured as an acquisition of assets, not stock, goodwill is no longer amortizable for accounting purposes, but it remains amortizable for tax purposes. The acquiring company’s earnings do not improve as with an acquisition of stock, since the company must take a charge against earnings through a deferred tax provision.

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That tax charge, Willens says, exactly counterbalances the acquiring company’s improvement in cash flow. The charge is calculated by multiplying the tax rate of 40 percent by the amortization that the company takes for tax purposes (but, again, not for accounting purposes). The result, under FAS 142, is improved cash flow but less of an earnings benefit.

This comes as a surprise to many CFOs and tax analysts because “people didn’t expect FASB to go this way,” according to Willens. “FASB decided that the difference between the accounting amortization and the tax amortization [was] a ‘temporary difference’ — that is, you have to provide those deferred taxes. We all thought that FASB would take the other approach, treating the difference as ‘permanent’ — that is, [the post-merger] company would not have to incur that tax charge.”

For Martin Headley, CFO of Roper Industries, that surprise is proving to be pesky: “We see the build-up of a fairly significant deteriorated tax liability on the balance sheet. You don’t get any earnings benefit for having negotiated a tax-deductible transaction.”

Other finance executives, however, are finding a benefit — in the tax rate. The new rules “gave us a very different effective rate,” reduced from 44 percent to the above-mentioned 40 percent, says Mary Kabacinski, CFO of School Specialty Inc. For School Specialty, a direct marketer of education supplies, that lower tax rate means higher pretax income. And shareholders notice that, says Kabacinski: “The effective tax rate doesn’t change anything from a cash perspective, but people do look at the effective rate. It’s part of what our shareholders would analyze.”

In the big picture, though, few deals will be affected, because of the prerequisite that a deal must be a taxable purchase of a corporation’s assets, rather than its stock. “Not that many deals are structured in that manner,” says Willens. “I would say the vast minority of deals creates tax-deductible, or tax-amortizable, goodwill.”

What Do You Do When You’re Branded?

Aside from direct effects on the balance sheet, says Steve Goeben of PricewaterhouseCoopers LLP, other tax positions that depend on intangible assets may be affected, particularly in the area of trademarks and brands.

For instance, say that a year after an acquisition, a brand becomes impaired under FASB’s new rules, and the post-merger company recognizes the impairment on its balance sheet. If there’s a royalty charge to an affiliate, the Internal Revenue Service (or other tax authority) might argue that the royalty is overstated. Usually, companies try to manage intangibles in a low-tax jurisdiction and charge out royalties to entities that use the intangible in a high-tax jurisdiction. In such a case, says Goeben, “any decrease in the royalty expense will cause an increase in a company’s global tax burden.”

In addition, it’s rare for companies to leave acquired intangibles on the shelf — especially tech-based intangibles — because companies tend to build on the acquired technology continually. And when individual intangibles are combined into larger groups, says Goeben, even if impairment occurs in one intangible, it doesn’t necessarily force a deduction in the value of the entire group.

For example, take a big software company that goes through a regular series of acquisitions to build on an existing suite of products. In a case where a given brand is no longer “sold” separately, even though an acquired intangible might be impaired, the suite as a whole might still be able to command a premium. The whole group of acquired assets, says Goeben, might well contain so many pieces that if one tiny component were impaired, it would not necessarily offset the charge of royalties.

“Leave yourself more flexibility by choosing broader reporting units for your intangibles,” suggests Goeben. “Blend a number of different rights (to trademarks and brands) together in a package, so that you only pay a single tax on royalties per package.”

The bottom line, says Goeben, is to prepare tax strategies in advance. “If you restructure, at least anticipate what [FAS 142] might mean to your tax position,” he says. “If there is an impairment issue in a later year, the tax department should be preparing a defense file.”