25th Annual Health Sciences Tax Conference - EY

25th Annual Health Sciences Tax Conference Income tax accounting for strategic transactions – acquisitions, divestitures and internal restructurings December 7, 2015

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EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US.

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Views expressed in this presentation are those of the speakers and do not necessarily represent the views of Ernst & Young LLP.

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This presentation is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide tax advice to any taxpayer because it does not take into account any specific taxpayer’s facts and circumstances. These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice.

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Income tax accounting for strategic transactions – acquisitions, divestitures and internal restructurings

Presenters ►

Tricia Brosnan

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Pfizer Peapack, NJ ►

Ernst & Young LLP New York, NY [email protected] +1 212 773 8569

Jacqueline Perotti Actavis Parsippany, NJ

Joan Schumaker

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Kristen Gray Ernst & Young LLP New York, NY [email protected] +1 212 773 3560

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Agenda ► ► ► ► ► ► ►

Introduction Acquisition accounting considerations Post-merger integration Restructuring scenarios Separate financial statements of a subsidiary Spin-off transactions Regulatory developments

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Strategic transactions

Need for a coordinated end-to-end process ►

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Time of unprecedented opportunity and challenge for multinational organizations ►

Mergers, acquisitions and divestitures

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Treasury matters

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Legislative and regulatory changes, increased compliance requirements and controversy

Tax function’s goals ►

Maximize and maintain global liquidity

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Maintain accuracy in financial reporting

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Focus on effective tax rate (ETR) management

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Establish and sustain tax positions and maximize tax attributes

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Increase certainty and minimize risk

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Acquisition accounting considerations – Accounting Standards Codification (ASC) 805 ►

Overall principle ► ►

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Acquirer obtains control of target. Fair value of underlying exchange establishes new accounting basis.

The acquirer recognizes and measures the assets acquired and liabilities assumed at their fair values as of the date control is obtained, regardless of the percentage ownership in the acquiree or how the acquisition was achieved (e.g., a business combination achieved in stages, a single purchase resulting in control, or a change in control without a purchase of equity interests). ►

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Referred to as the acquisition method


Acquisition method ►

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ASC 805 requires that all consideration transferred (i.e., the purchase price) be measured at its acquisition-date fair value. Goodwill arises in business combinations when the purchase price exceeds the assigned values of tangible and identifiable intangible assets acquired, less liabilities assumed. Amounts assigned to particular assets and liabilities may differ for financial reporting and tax purposes. ASC 740 requires deferred tax liabilities and assets to be recognized for the deferred tax consequences of those temporary differences and for operating loss or tax credit carryforwards. ►

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Exceptions: ►

The portion of goodwill that is not deductible for tax purposes

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Acquired outside basis differences that meet the indefinite reversal exception for recognition of a deferred tax liability


Measurement period ►

Time after acquisition to obtain information identifying and measuring all aspects of the business combination ► ►

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Not a fixed period Ends when all information that existed at acquisition date is obtained or is unavailable Cannot exceed one year

All subsequent changes recorded in earnings

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Measurement period adjustments ►

When new or additional information is identified during the measurement period about facts and circumstances that existed as of the acquisition date, provisional amounts recognized at the acquisition date should be adjusted only if the new information: ►

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Affects the measurement of items that were initially recognized at the acquisition date Establishes that an additional asset was acquired or a liability was assumed that was not recognized in the initial accounting for the acquisition Or Establishes that an asset or a liability that was previously recognized at the acquisition date does not meet the recognition requirements of ASC 805


Measurement period adjustments ►

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The acquirer generally adjusts provisional amounts by increasing or decreasing goodwill. The acquirer recognizes changes in carrying amounts of assets and liabilities that are the result of facts and circumstances that did not exist as of the acquisition date as part of ongoing operations (generally, as income or expense in the current statement of operations).

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Share-based payments ►

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Acquirers often exchange share-based payment awards (i.e., replacement awards) for awards held by employees of an acquired business. Under ASC 805, if an acquirer is obligated to issue replacement awards in exchange for acquiree share-based payment awards held by employees of the acquiree, then all or a portion of the fair value of the acquirer’s replacement awards should be included as part of the consideration transferred by the acquirer. Generally, the portion of the replacement award that is part of the consideration transferred is the amount that is attributable to past service, whereas the portion attributable to future service is recognized as compensation expense as that service is rendered.

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Share-based payments ►

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To the extent that the cost of such replacement awards is considered part of consideration transferred, related deferred taxes should be accounted for as an element of consideration transferred in the business combination if the replacement award is expected to result in a future tax deduction under existing tax law. To the extent that the cost of such replacement awards is recognized as post-combination compensation cost, a deferred tax asset would generally be established (through income tax expense) as that compensation cost is recognized. Any ultimately realized tax benefit associated with the replacement share-based payment awards (i.e., the excess or deficiency) is accounted for without regard to whether the benefit is related to (sourced from) consideration transferred in the business combination or post-combination compensation cost.

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Acquired research and development deferred tax liabilities ►

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ASC 805 requires an acquirer to recognize all tangible and intangible assets to be used in research and development that are acquired in a business combination (acquired R&D) as assets for financial reporting purposes (i.e., the amounts allocated to these assets are no longer expensed on the acquisition date). As the book basis of acquired R&D assets typically exceeds the tax basis, a deferred tax liability generally will be reported related to this temporary difference. Subsequent to the acquisition date, acquired R&D capitalized as a result of a business combination is accounted for pursuant to the provisions of ASC 350, Intangibles — Goodwill and Other, which specifies that intangible assets acquired for use in a particular R&D project are considered indefinite-lived intangible assets until the completion or abandonment of the associated R&D efforts.

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If R&D is successful in the future … ►

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At completion of the development process for the acquired R&D, the acquirer determines useful life. Prior to changing its life from indefinite to finite, the asset is tested for impairment under ASC 350-30 as if it were still indefinite-lived. If it is subsequently transferred to a different jurisdiction in an intercompany transaction, then the intercompany transaction rules would need to be considered. ►

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If Accounting Research Bulletin (ARB) 51 does not apply, there may be a tax provision impact.


Investments in foreign subsidiaries ►

Assertion regarding indefinite reinvestment ►

In a business combination, the acquiring company must make its own determination as to the reinvestment strategy related to any acquired foreign operations. ►

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In contrast, the tax effects of a change in indefinite reinvestment assertion related to an acquiring company’s existing outside basis differences are recognized outside of the business combination in continuing operations in the period the change occurs. ►

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To the extent the purchaser does not assert indefinite reinvestment of the outside basis difference related to acquired foreign operations, deferred tax liabilities associated with those basis differences would be recognized in acquisition accounting regardless of the pre-acquisition determination of the seller.

Following a business combination, an acquiring company may choose to implement a restructuring plan to integrate the acquired foreign operations into its existing operating structure.


Tax effects of outside basis differences in foreign subs ►

Acquiring (US)

Buyer makes its own indefinite reinvestment assertion for Target CFCs. ►

Acquiring Sub (US)

Target (US)

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APB 23

Acquiring Fgn Sub (CFC)

Target Fgn Sub (CFC)

CFC — controlled foreign corporation

inside basis for assets and liabilities

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Regardless of pre-acquisition determination of the seller Record effects in acquisition accounting Measure any resulting deferred tax liability (DTL), taking into account expected means of reversal of basis difference Only record deferred tax asset (DTA) (i.e., tax basis > fair market value (FMV)) if reversal of basis difference expected in foreseeable future

Change in assertion for Acquiring Co’s foreign subs — DTL not in purchase accounting.


Valuation allowances ►

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ASC 740 requires the acquiring company to recognize a valuation allowance to reduce the carrying amount of the acquired deferred tax assets to an amount that is more likely than not to be realized through acquisition accounting. A change in an acquirer’s valuation allowance for a deferred tax asset that results from a change in the acquirer’s circumstances caused by a business combination should be accounted for as an event separate from the business combination.

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Unrecognized tax benefits ►

Tax bases used in the calculation of deferred tax assets and liabilities, as well as amounts due to or receivable from taxing authorities related to prior tax positions (i.e., acquired uncertain tax positions (UTPs) at the date of a business combination, shall be calculated in accordance with Subtopic 740-10 (ASC 805-740-25-5) through acquisition accounting.

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State tax rates ►

Deferred taxes acquired in a business combination should be measured based on the expected tax consequences to the combined entity, even if such measurement is affected by acquirer-specific attributes. ►

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The acquirer should not separately calculate deferred taxes using the acquiree’s historic rate, and only include that portion in acquisition accounting and the remainder in the acquirer’s current income statement.

If the tax rate (including consideration of income apportionment) applicable to existing deductible or taxable temporary differences of the acquirer changes as a result of a business combination, the effect of the change should be reported in current operating results and not in acquisition accounting.

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Tax accounting considerations ► ► ► ►

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Audit settlements Return to provision (RTP) adjustments Transfer pricing adjustments Identifying and re-assessing valuation allowances and uncertain tax positions Valuation allowances State tax rate Determining indefinite reinvestment assertions Do not underestimate the time needed to address these items

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Other implementation challenges in business combinations ►

Data gathering process ►

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Review of acquired tax balances – current and deferred

Identifying changes within the measurement period that are attributable to adjustments to provisional amounts, changes in estimates or errors Push down of valuation by jurisdiction Tracking topside adjustments recorded for acquired assets and liabilities Pro forma financial statements

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Post-merger integration (PMI) planning ►

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Early involvement of tax accounting personnel in the planning process is critical to gain an understanding of the accounting consequences of PMI planning. Key goals include effective cash management, cost synergies and operational efficiency. Tax accounting focus areas for PMI planning: ►

Day one vs. day two

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Uncertain tax positions

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Changes in valuation allowances

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Foreign tax credits (FTCs) on unremitted earnings of foreign subsidiaries (i.e., “unborn” FTCs)

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Outside basis difference of foreign subsidiaries and assertion

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Immediate tax consequences

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Assumed facts for examples FMV

Tax basis

E&P

Taxes

Target CFC

$100

$30

$70

$30

Acquiring CFC

NA

NA

$50

$50

Acquiring Co (US)

Acquiring Co Sub (US)

Target Co (US)

Acquiring Co Sub (CFC)

Target Co Sub (CFC)

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Both CFCs’ earnings and profits (E&P) indefinitely reinvested prior to acquisition


Example 1 – Target CFC dividend ►

Acquiring Co (US) Acquiring Co Sub (US) Acquiring Co Sub (CFC)

Target Co (US)

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$70 div

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Target Co Sub (CFC)

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Potential cash tax cost of $5 (35% times $100 dividend including gross-up) less $30 FTCs) Timing of change in assertion: Acquisition date – DTL in purchase accounting After acquisition date – DTL not in purchase accounting

What if liquidation (actual or deemed) of Target CFC instead of an actual dividend?


Example 2 – cross-chain sale of Target CFC to Acquiring CFC for $100 ►

Acquiring Co (US) Acquiring Co Sub (US) Acquiring Co Sub (CFC)

Target Co (US)

$100

Target CFC stock

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Target Co Sub (CFC) Page 25

§304(a)(1) transaction ►

$50 E&P from Acquiring Co CFC

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$50 E&P from Target CFC

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Cash tax cost of $0 and excess credits of $11.15 (35% times $171 less $71 FTCs)

Change in assertion at acquisition date ►

Target CFC $3.85 DTL (35% times $71 less $21 FTCs) in purchase accounting

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Acquiring Co $15 DTA (35% times $100 less $50 FTCs) not in purchase accounting

Change in assertion after acquisition date – DTA and DTL not in purchase accounting What if US check-the-box election filed for Target CFC two days after sale (i.e., “All Cash D Reorganization” for US tax purposes of Target CFC)?


Integration challenges ►

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A transaction entered into by or on behalf of the acquirer or primarily for the benefit of the acquirer or the combined entity, rather than primarily for the benefit of the acquiree (or its former owners) before the combination, is likely to be a separate transaction (ASC 805-10-25-21). The acquirer should consider the following factors, which are neither mutually exclusive nor individually conclusive, to determine whether a transaction is part of the exchange for the acquiree or whether the transaction is separate from the business combination: ► ► ►

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Reasons for the transaction Who initiated the transaction Timing of the transaction


Post-combination intercompany transactions ►

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Subsequent to a business combination, the acquirer may enter into intercompany transactions as part of its overall tax structure (e.g., an intercompany transfer of acquired intellectual property). Such transactions may be contemplated at the time of the business combination or occur during the measurement period. Questions often arise as to whether such transactions should be considered part of the business combination. Post-combination intercompany transactions are typically entered into at the sole discretion of the acquirer and the tax effects of such transactions are accounted for outside of the business combination (ASC 805-10-25-21).

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Divestitures

Separate financial statements of a subsidiary ►

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Could be referred to as “carve-out” (i.e., financial statements of a business that is not a legal entity, such as a division) or “stand alone” financial statements Prepared for internal, regulatory or separate reporting purposes and often prepared in anticipation of a disposition, spin-off, business combination or initial public offering

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Income tax accounting considerations Separate-return method ►

Current and deferred taxes are allocated as if each member were a separate taxpayer. ►

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Under this method, the sum of the amounts allocated to individual members of the income tax return group may not equal the consolidated amount (ASC 740-10-30-27).

For financial statements included in an SEC filing, if income taxes have not been computed on a separatereturn basis in the historical financial statements, a pro forma income statement for the most recent year and interim period, reflecting a tax provision calculated on a separate return basis, is required.

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Income tax accounting Common considerations ► ► ► ►

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Understand the purpose of the separate financial statements Remember that sum of parts may not equal whole Consider legal entity structure in historic financial statements Prepare separate determination of permanent tax benefits (e.g., Section 199 domestic production deduction, R&D credits) Push down of corporate costs and related deferred tax effects Consider US inclusions of foreign earnings – Subpart F, Section 956, distributions, foreign tax credit calculations Provide transparent disclosures Do not underestimate the time needed to calculate provisions, related deferred tax balances and disclosures for separate financial statements

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Planning considerations ► ►

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Understand materiality on a separate reporting basis Coordinate with finance group and attest firm at the beginning of the process to agree on methodology Stay connected with finance group and other teams Understand how legal entities, disregarded entities and branches are treated in historical financial statements Determine what accounting information will be available (e.g., ledgers, Excel templates, supporting schedules, push down/topside entries) and identify tax-sensitive accounts Understand the periods to be presented

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Spin-off involving CFCs: Part I

2

Holdco (CFC)

Spinco stock Remainco (CFC)

Spinco (CFC)

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Holdco (CFC)

1

Spinco stock

Remainco (CFC) Business A

Spinco (CFC) Business B

Business B assets

US federal income tax considerations ►

Subpart F income: if the distribution of the stock of Spinco does not qualify as tax free for US federal income tax purposes, it generally results in Subpart F income.

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Earnings and profits (E&P) in general and previously taxed income (PTI) in particular: there are open questions about if, and how, these tax attributes are allocated in a spin-off. This requires close coordination between Tax and Treasury to best position these attributes.

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Local distributable reserve/withholding tax issues may apply to stock distribution.

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Spin-off involving CFCs: Part II Pursuant to a binding agreement, the following occurs: 3

Holdco (CFC)

Cash

Remainco (CFC) Cash

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2

Holdco (CFC)

1 Cash equal to the value of Business B assets Spinco (CFC)

Remainco (CFC)

Business B assets

Business A

Spinco (CFC) Business B

US federal income tax considerations ►

Under local law, a tax-free transaction may not be available, or may impose undesirable restrictions, such as holding period requirements. Taxpayers must weigh the foreign tax cost against, among other things, the ability to use foreign tax credits.

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Even if taxable locally, it may still qualify as tax-free “drop-and-spin” from a US perspective, under authorities such as Rev. Rul. 77-191 and Rev. Rul. 83-142.

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Local distributable reserve/withholding tax issues may apply to cash distribution in step 3.

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Other restructuring/separation income tax accounting considerations ► ► ► ► ►

Intercompany transaction exception Realizability of gross deferred tax assets Share-based payments Outside basis differences in foreign and domestic subsidiaries Uncertain tax positions

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FASB income taxes simplification ►

Requires classification of all deferred tax assets and liabilities as noncurrent ►

Companies no longer required to allocate valuation allowances between current and non-current

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No change to jurisdictional offsetting requirements

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Prospective or retrospective transition permitted

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For public business entities, FASB-proposed amendments effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2016

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For non-public business entities, FASB-proposed amendments effective for annual periods beginning after December 15, 2017, and interim periods in annual periods beginning after December 15, 2018

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Early adoption permitted by all entities as of the beginning of any interim or year-end period

FASB is drafting a final standard. Page 35


Questions?

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25th Annual Health Sciences Tax Conference - EY

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