Purchase Accounting and Business Acquisitions

Part 2 of the Series

What is Purchase Price Accounting (‘PPA’)

It?is an accounting process used in Business Combinations. It involves assigning a fair value to all the acquired assets and liabilities of the target company. ?This process ensures that the financial statements accurately reflect the fair value of the acquired assets and liabilities, as well as any goodwill arising from the acquisition.

Goodwill is calculated as a difference between the purchase price and the total fair market value of assets and liabilities of an acquired company. The goodwill on acquisition is not amortized but tested for impairment on an annual basis. If the acquisition price is less than the value of the acquired assets, the shortfall is treated as a bargain purchase gain (negative goodwill) and require a corresponding income inclusion.

PPA adjustments?are typically made at the top-side level during the consolidation process. This means that the adjustments are recorded at the parent company level rather than at the subsidiary level. However, certain accounting standards permit push down accounting, e.g. US GAAP, while it is not permitted in other accounting standards, like IFRS.

PPA adjustment in Financial Accounting Net Income or Loss (‘FANIL’)

Under Globe Rules, adjustments to income or expense attributable to purchase accounting for an acquired business that are reflected in the MNE Group’s consolidated accounts, rather than a Constituent Entity’s separate accounts, are not considered in the computation of a Constituent Entity’s FANIL. FANIL is the standalone Net Profit (or Loss) of each constituent entity and serves as the starting point for Globe calculations.

Thus, in case of MNEs where PPA adjustments are pushed down as per the relevant accounting standard, the standalone net profit or loss numbers need to be adjusted to eliminate its impact.

Illustration: MNE Group ABC acquired Co XYZ for $1000 million. The fair value of Co XYZ’s net identifiable assets acquired was to the tune of $900 million on the date of acquisition. The book value of the net identifiable assets of Co XYZ as of the date of acquisition is $800 million. Co XYZ chooses to apply pushdown accounting in its standalone financial statements and thus will recognize the following elements after acquisition:

Goodwill on acquisition = consideration paid - net assets (fair value) = $1000 million – $900 million = $100 million

Net Assets acquired (fair value) = $900 million (after a PPA step up of $100 million, i.e. $900 million - $800 million)

For determining FANIL under the Globe Rules, Goodwill on acquisition of $100 million and PPA step up of $100 million may need to be eliminated to the extent included in net profit (or loss) of a constituent entity (as reversals/amortization/write back).

Typically, following cases of business acquisitions result in PPA adjustment: ?

• Share deal (acquisition through share purchase) – PPA adjustments to be eliminated in accordance with Article 3.1.2 of the Globe Rules
• Asset deal (Business Transfer Arrangement) – PPA adjustments to be eliminated only if such asset deal qualifies as Globe Reorganization under Article 6.3.2 of the Globe Rules

Exceptions for PPA adjustments under FANIL:

• Asset deal qualifying as business combination but that do not qualify as Globe Reorganization under Globe Rules
• Acquisitions prior to December 1, 2021, but only if the MNE Group does not have sufficient records to determine its FANIL with reasonable accuracy based on the unadjusted carrying values of the acquired assets and liabilities

Adjustment to Deferred taxes for PPA

• The change in fair value of acquired assets and liabilities is usually not reflected in the tax base and so, a temporary difference arises. Deferred Tax Liabilities/Deferred Tax Assets (‘DTL/DTA’) arising due to such taxable/deductible temporary difference is recorded on account of Goodwill, in cases of Business Combinations. Hence, no deferred tax expense or benefit results upon initial recognition of DTA or DTL due to acquired assets or liabilities. However, when this DTL or DTA reverses, it results in a tax benefit or expense, accordingly.
• As per the provisions of Article 4.4.1(a) of the Globe Rules, the amount of deferred tax expense (benefit) with respect to items excluded from the computation of Globe income or loss should also be eliminated. Thus, if PPA push down is reversed for Globe purposes, the corresponding deferred taxes should also be eliminated from the computation of Adjusted Covered Taxes.

PPA adjustments included in Substance-based Income Exclusion

• The Substance-based Income Exclusion amount for a jurisdiction is the sum of the payroll carve-out and the tangible asset carve-out for each Constituent Entity. Globe Rules require that for the purpose of determining the tangible asset carve-out, the carrying value of asset shall be considered after taking into account purchase accounting adjustments.
• Hence, while the Globe Rules require the PPA adjustments to be reversed for determining FANIL, such PPA adjustments are required to be included in the computation of Substance-based Income Exclusion amount.

PPA adjustments in Transitional CbCR Safe Harbour

The Administrative Guidance issued by the OECD in December 2023 clarified that financial statements inclusive of PPA adjustments can be said to be ‘Qualified Financial Statements’ for the purposes of Transitional CbCR Safe Harbour, provided the following conditions are met:

• Consistent Reporting Condition: CbCR for fiscal year beginning after 31 December 2022 is based on Constituent Entity’s reporting package or financial statements inclusive of PPA adjustments and if the financial statements are not inclusive of PPA adjustments, Constituent Entity was required by law to change its reporting package or separate financial statements to include PPA adjustments.
• Goodwill impairment adjustment. Any reduction to the Constituent Entity’s income attributable to an impairment of goodwill related to transactions entered into after 30 November 2021 must be added back to the Profit (or Loss) Before Taxes (a) for purposes of applying the routine profits test; and (b) for purposes of applying the simplified ETR test, but only if the financial accounts do not also have a reversal of DTL or recognition or increase of a DTA in respect of the impairment of goodwill.

The condition of Goodwill impairment adjustment for simplified ETR test is usually met, because generally accounting standards provide for an exception to not recognize DTL from initial measurement of goodwill on acquisition.

In conclusion, given the diverse treatment of PPA adjustments under Pillar Two law, it is crucial for MNEs to meticulously identify these cases and ensure they are fully prepared to comply with the pertinent provisions. By doing so, MNEs can avert potential compliance issues, optimize their tax positions, and uphold the integrity of their financial reporting.