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Tax considerations: the use of fair-value accounting in the U.S. has accelerated in recent years as a means of enhancing financial statement quality, transparency and relevance. With the trend toward global convergence--where fair-value measurement is even more prevalent--here are highlights of certain tax considerations.

Elements of fair-value accounting have been used for decades in United States generally accepted accounting principles. While the growth of fair-value accounting has been incremental in the U.S., its use has accelerated in recent years as a means of enhancing financial statement quality, transparency and relevance.

An increasing variety of assets and liabilities are subject either to required or elective fair-value accounting. This trend aligns with global accounting convergence, as the use of fair-value measurement is even more prevalent in International Financial Reporting Standards.

The following highlights certain tax considerations associated with the evolution toward fair-value accounting. (A partial timeline of recent U.S. GAAP pronouncements begins on page 50.)

Effects of Tax Considerations on Fair-Value Measurements

Tax considerations can have a direct effect on the use of the income- (or discounted cash flows) valuation approach for fair-value measurements used in financial accounting.

For example, tax amortization benefits--which are the cash flows expected from tax depreciation or amortization deductions--are generally included in the assigned value of an asset acquired in a business combination and may be considered when performing tests for impairment under FAS 142 and FAS 144. Tax benefits associated with assumed liabilities are likewise to be considered.

Fair-value measurement should reflect tax amortization benefits irrespective of whether the particular owner acquired the asset in a manner that provides amortizable tax basis, or whether the owner is a tax-paying entity, and regardless of an owner's loss or credit carryforwards.

That is, the benefits are included from the viewpoint of a neutral "market participant" (or third party). Consideration may also be given to tax-planning strategies that would typically be available to a market participant.

At the same time, the tax benefits should reflect the tax laws of the jurisdiction(s) that applies to the assets or liabilities. If there are no tax benefits possible (in any circumstance) under the relevant jurisdiction's tax laws, the fair-value measurement should not include tax benefits. When the relevant tax laws provide for tax benefits, the timing and amount of tax benefit cash flow should be considered.

Also important to consider: tax laws governing purchase-price allocations in taxable business acquisitions or in certain asset exchanges may not follow applicable book principles.

There may be different valuation approaches or models that are permitted or required under the tax laws. In addition, for financial reporting purposes, goodwill impairment testing is performed on a reporting-unit basis, which typically reflects an assignment of assets and liabilities across legal entities.

An assessment of potential fair-value measurement may be needed for contingencies relating to taxes that are not based on income (e.g., sales and use, property, gross receipts, VAT, duties and excise taxes). FAS 141(R), the new standard on business combinations (effective in 2009 for calendar-year companies), requires fair-value measurement for certain acquired contingencies.

Last December, FASB released a proposed amendment limiting that measurement to contingencies having a fair value that can be "reasonably determined," and it also provided some guidance for making that assessment.

Effects of Fair-Value Measurements on Cash Taxes

The tax consequences of fair-value measurements may be significant in jurisdictions that have taxes based partially or entirely on net worth. Some state and local jurisdictions in the U.S. have taxes based on net worth or equity, including certain franchise taxes for the privilege of doing business in the jurisdiction.

There are also foreign jurisdictions that have hybrid tax systems under which the tax payable is based on a measurement of net income or net assets, whichever produces more tax revenue. To the extent such taxes are based upon capital value or financial statement shareholders' equity, fair-value measurements will directly impact cash taxes payable.

Even within an income tax system, particular items of income or deduction may be affected by fair-value accounting measurements. For example, U.S. federal tax law permits dealers in securities and/or commodities to mark-to-market their assets using fair values reported in eligible financial statements.

The Internal Revenue Service is now considering expanding the definition of eligible financial statements to include financial statements prepared under IFRS.

Effects of Fair-Value Accounting on Income-Tax Accounting

The U.S. GAAP and IFRS accounting for income tax standards (FAS 109 and IAS 12, respectively) currently require a "balance sheet" approach to recognizing and measuring deferred income taxes. The book carrying amounts of assets and liabilities reported on a balance sheet are compared with their tax bases and the resulting differences, with limited exceptions, are considered taxable or deductible temporary differences.

To the extent that fair-value measurements impact book carrying amounts, the measurements thereby affect the calculation of temporary differences and recognition of deferred taxes.

Market volatility in some cases can even have a material impact on the enterprise's effective tax rate. Consider an available-for-sale, marketable debt security that has suffered other-than-temporary impairment (OTTI) in value because of the issuer's credit risk.

Although, OTTI is recognized in income, it may not be deductible on a tax return until the unrealized loss is realized through a sale, liquidation or other disposition. In that case, it would create a deductible temporary difference and a deferred tax asset that must be assessed for realization.

To the extent the asset requires a valuation allowance (or, in IFRS accounts, cannot be recognized), there will generally be an impact on the effective tax rate. Consider, also, an equity security that had previously appreciated in value. The unrealized book gain represents a taxable temporary difference for which a deferred tax liability was recognized.

If the value of that security "flips" to below its tax basis (e.g., original cost), the unrealized book loss represents a deductible temporary difference for which a deferred tax asset is recognized, subject to a valuation allowance assessment.

If the deferred tax liability that previously existed was a source of income that supported a conclusion that a valuation allowance was not necessary, the reversal in value has a dual impact: it removes a potential source of income and it increases the total deferred tax assets potentially requiring a valuation allowance.

Similar consequences may arise, for example, with respect to a financial institution that has elected under FAS 159 to apply the fair-value option to measuring its own debt obligations. Likewise, pursuant to FAS 159, an entity may elect to fair value an investment that has been accounted for under the equity method of accounting.

In each of these (and many other similar) circumstances, fair-value measurements will affect deferred taxes and potential valuation allowance considerations.

The changes introduced by FAS 141(R) place greater emphasis on fair-value accounting and in differentiating acquisition accounting from accounting for acquirer-specific and post-acquisition events. Increased volatility can be expected both in pretax earnings and in effective tax rates.

For share-based compensation, FAS 123(R) requires the recording of anticipated future tax benefits relating to various awards that are recorded using a fair-value-based method as they vest. At the same time, however, respective deferred tax assets are not to be re-measured or derecognized based on the increase or decline in the fair value of the award

This principle differs from IFRS wherein tax benefits are generally reported (or re-measured) based on the fair value of the stock at each reporting date.

Effects of Fair-Value Accounting on Tax Planning

Fair-value accounting can have tax strategy and planning implications. In business acquisitions under FAS 141(R), for example, in-process research and development will be capitalized at fair value.

As a result, subsequent taxable transfers or cost-sharing related to those projects may need to be analyzed with reference to such fair values. Companies should assess and document any departures from such reported values for transfer-pricing purposes.

Fair-value measurements will also be applied to more acquired liabilities and contingencies and to contingent purchase price arrangements. It will be important to assess and differentiate any associated tax analysis of those matters.

Tax planning for compensatory share-based award programs needs to be approached with care so that effective tax rate benefits are sufficiently certain. This includes emphasis on compliance with various tax-qualification rules for domestic awards programs, as well as establishment of effective cross-border chargeback arrangements to support tax benefits available outside the U.S.

Fair-value measurements may affect debt-equity ratios and other financial metrics. These metrics may have tax impacts in areas such as inter-company pricing and intercompany debt, which can vary across tax jurisdictions.

Fair-value accounting can also apply to a company that indemnifies another company's tax obligations. Tax indemnifications might arise in a sale of a business, a spinoff, a joint venture or similar transactions.

When the indemnifying party (or guarantor) is not legally obligated (under the tax law) to pay taxes covered by an indemnification agreement, FIN 45 may apply to require the guarantor to recognize a liability for the fair value of the guarantee at inception.

The intersection of tax law, tax accounting and fair-value accounting can have significant effects on a company's financial profile.

It is important for tax managers to be closely involved in the consideration of pretax accounting analysis, fair-value accounting measurements, due diligence for transactions and the cash and tax-planning implications of fair-value accounting.

RELATED ARTICLE: Evolution of Fair-Value Accounting


FAS 115

Accounting for Certain Investments in Debt and Equity Securities. Requiring fair-value measurement of certain debt and equity marketable securities with readily determinable fair values.


FAS 133

Accounting for Derivative Instruments and Hedging Activities. Requiring fair-value measurement for derivatives.


FAS 140

Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Debt. Allowing fair-value measurement, when practicable, for initial measurement of liabilities and derivatives incurred and obtained as part of a transfer of financial assets.


FAS 141

Business Combinations. Establishing fair-value measurement as equivalent to the "cost" of acquiring a business;

FAS 142

Goodwill and Other intangible Assets. Requiring initial recognition of acquired intangibles at fair value and establishing fair value as a benchmark for impairment analysis;

FAS 144

Accounting for the Impairment or Disposal of Long-Lived Assets. Requiring the use of fair-value measurement to assess whether long-lived assets are impaired.


FIN 45

Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Direct Guarantees of Indebtedness of Others. Requiring fair-value measurement objective of certain obligations such as a stand-ready obligation to perform and make future payments (i.e., a guarantee).


FAS 150

Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. Requiring certain financial instruments classified as liabilities to be recognized initially and subsequently at fair value.


FAS 123 (Revised) Share-Based Payment. Requiring stock-based compensation granted to employees to be recognized using a fair-value-based method.


FAS 157, Fair Value Measurements. Providing for the first time a U.S. GAAP framework for measuring fair value. Also, in 2006 FAS 140 was amended by FAS 155, Accounting for Certain Hybrid Financial Instruments and by FAS 156, Accounting for Servicing of Financial Assets. Requiring fair-value measurement on initial recognition of all separately recognized servicing assets and liabilities and permitting fair value measurement of hybrid instruments that contain an embedded derivative.


FAS 159

The Fair Value Option for Financial Assets and Financial Liabilities. Permitting fair-value measurement for many more financial assets and liabilities; FAS 141 (Revised) Business Combinations. Requiring fair-value measurement for all assets acquired and liabilities assumed in a business combination.

Source: Price waterhouse Coopers

EDWARD ABAHOONIE ( is a partner and national office 'Tax Accounting Services Technical Leader and YOSEF BARBUT ( is a director, national office. Both are with PricewaterhouseCoopers in Florham Park, N.J.
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Author:Abahoonie, Edward; Barbut, Yosef
Publication:Financial Executive
Geographic Code:1USA
Date:Mar 1, 2009
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