How To Manage Purchase Price Allocation (PPA) For Tax Purposes
Posted by Valentiam Group on March 4, 2020
Mergers and acquisitions (M&As) present exciting opportunities for companies to grow and thrive in a competitive environment—but they also introduce new tax and financial reporting requirements. One of those requirements is a purchase price allocation (PPA), which is a fair value analysis performed by the buyer to help inform their investors on what was acquired in an merger or acquisition. Purchase price allocations are an important requirement in financial reporting and can have an impact on income tax filings to the Internal Revenue Service (IRS). In this article we’ll focus on the basics of a PPA and the significance for income tax purposes specifically.
Below is an overview of purchase price allocations and their use for tax purposes, along with some tips for complying with reporting requirements and managing future tax obligations.
How are purchase price allocations used for tax purposes?
A purchase price allocation, for the purchase of a business, is a valuation under ASC 805 that determines the fair value of all intangible and identifiable intangible assets with the residual value being considered goodwill. The PPA is performed by an independent appraiser or valuation expert to determine the fair market value (FMV) of all assets. The rules governing purchase price allocations for financial reporting are mandated by the Financial Accounting Standards Board (FASB).
Identification and categorization of a company’s tangible assets, intangible assets, and any liabilities assumed in an M&A is a significant component of purchase price allocation. Both the buyer and seller in a M&A transaction must report the allocation of the transaction on their annual tax returns (Form 5894) to comply with IRS regulations.
In Section 1067 of the U.S. tax code, the IRS stipulates that a purchase price must be allocated to these assets under the residual method, which breaks assets down into categories that dictate the applicable tax rates. Here’s a breakdown of the asset classes:
- Class I: Cash and cash equivalents
- Class II: Actively traded personal property, certificates of deposit, and foreign currency
- Class III: Accounts receivables, mortgages, and credit card receivables
- Class IV: Inventory
- Class V: All uncategorized assets (equipment, land, property)
- Class VI: Section 197 intangibles, minus goodwill or going concern
- Class VII: Goodwill and going concern
The PPA can be used to properly allocate the value of the transactions to the different classes of assets required under Section 1067. In the PPA, the appraiser will determine the value of all tangible and identifiable intangible assets associated with the purchase and goodwill, which is only determined in business acquisitions and is calculated by subtracting the identifiable assets and write-ups from the total purchase price. Write-ups are determined following the PPA.
Depending on the type of transaction, PPAs are important because they can set the initial tax basis, determining how each of the acquired organization’s assets will be taxed in the future. (Tweet this!) The initial tax basis of each asset determines any post-acquisition deductions that can be taken for depreciation and amortization. Failure to ensure a proper PPA can have a significant impact on the acquiring company’s opening balance sheet, mislead investors and and ultimately affect tax liability.
Planning an acquisition in the near future? Talk to us as part of your acquisition planning strategy to make sure you’re meeting your compliance requirements.
An Example Of How PPAs Are Used For Tax Reporting
In this scenario, there are two companies: Company A and Company B. Company A is acquiring 100% of Company B’s assets for a purchase price of $20 million.
Based on book value, Company B’s assets are worth $15 million, while liabilities are valued at $3 million. Therefore, Company B’s net identifiable assets are equal to $12 million ($15 million minus $3 million). A valuation specialist completes an appraisal and deems the FMV of Company B’s assets and liabilities is actually $14 million. As a result, Company A must recognize a $2 million write-up ($14 million minus $12 million) to adjust the book value to FMV.
To complete the purchase price allocation and determine how much of the $14 million to recognize as goodwill, the companies must use the following formula:
Total Purchase Price – Net Identifiable Assets + Write-up = Goodwill
In this scenario, the calculation breaks down this way:
$20 million – $12 million + $2 million = $6 million
Therefore, $6 million should be recognized as goodwill on subsequent tax returns. After the value is determined, Company A and Company B will both need to classify the assets to determine the tax basis and tax rate for each asset acquired during the transaction.
3 Tips For Proper Allocation Of Purchase Prices For Tax Purposes
1. Communicate with the appraiser or valuation expert to provide information and ensure the proper allocation of the transaction value.
Proper allocation of purchase prices can generate significant tax savings or cost, both during the acquisition year and in the future. As the acquirer or the seller you know the business best and what is valuable in the transaction. Communicating with the valuation expert performing the PPA will help keep everyone on the same page and avoid negative results.
For example, management believes the value of the transaction is in the intellectual property or software being acquired, however, the appraiser places the bulk of the value in tangible property. This would create higher tax liability.
2. Consider the future of the organization.
Companies completing purchase price allocations should consider what the organization might look like in the future. What does the acquiring company plan to do with the business from a tax and transfer pricing perspective? What will drive future cash flows?
The accuracy of PPAs is contingent on whether forecasts used for valuations are consistent with future approaches to transfer pricing. Unreliable profit forecasting that doesn’t take future operating models and transfer pricing policies into consideration can have serious tax consequences.
3. Align with other parties’ allocations.
Both the buyer and seller are required to report purchase price allocations to the IRS following an acquisition. It is important for the parties to communicate through the purchase price allocation process and engage with an appraiser that understands their business, and whose determination in the PPA will be respected by both parties.
If tax authorities recognize that the buyer and seller used different allocations, it may raise a red flag and increase the risk of an audit. As such, aligning on allocations represents the best interest of both parties, helping them avoid unwelcome attention from the IRS and minimize the risk of a dispute.
We Can Help You Manage Your Tax Obligations
Purchase price allocations are one of many tax implications during a merger or acquisition. If your company is planning an M&A transaction and researching the tax requirements, you may benefit from the guidance of an established valuation consultant with purchase price allocation expertise.
Valentiam is an independent transfer pricing and valuation consulting firm comprised of seasoned industry experts who have held executive positions in the Big Four accounting and advisory firms. Our consultants are trusted by the world’s leading organizations to assist with reconciliation of value for purchase price accounting and income tax purposes.
Let's talk about your business’ valuation needs and how we can help you meet your compliance requirements while managing tax obligations.
Topics: Transfer pricing
OECD BEPS guidelines require maintenance of both master and local files for transfer pricing. Here are the requirements—and a plan to ensure compliance.