DTL Creation in a Stock Deal, Explained
The question
Explain why a DTL is created in a stock acquisition but not in an asset acquisition (or a 338(h)(10)/336(e) election), in terms of book basis versus tax basis.
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The answer
A DTL is created in a stock acquisition because the book basis of the target's assets steps up to fair value while the tax basis stays locked at historical cost, so book depreciation outpaces tax depreciation and the resulting timing gap builds as a deferred tax liability.
In an asset acquisition or a 338(h)(10) election, the transaction is taxed as an asset sale, which means the tax basis also steps up to fair value right at closing. Book basis and tax basis now match on every written-up asset and new intangible, so there is no divergence, no book-tax timing difference, and no DTL.
That same step-up also makes goodwill tax-deductible over 15 years for tax purposes, even though book goodwill is never amortized under GAAP.
Accretion / dilution
| Acquirer standalone net income | 300 |
| + Target net income | 80 |
| + After-tax synergies | 15 |
| − After-tax incremental interest | (10) |
| Pro forma combined net income | 385 |
| Acquirer standalone EPS | $3.00 |
| Pro forma share count | 125 |
| Pro forma EPS | $3.08 |
| Accretion | 2.7% |
Also asked as
- Define a deferred tax liability in the context of an M&A write-up, and state the formula for computing the DTL created by a fair-value write-up.
- A target's inventory is written up by $40M and its PP&E by $100M in a stock deal, tax rate 25%. Compute the DTL created.
- Explain why goodwill is not tax-deductible in a typical stock deal but IS tax-deductible over 15 years in an asset deal, and why a buyer might therefore be willing to pay a higher price for the same target under an asset-deal structure.
- Walk through how a DTL created at close 'reverses' over time, and explain where that reversal appears in a three-statement model (which statement, which line).
- What is Section 382, and why does an acquired company's NOL carryforward often become less valuable to the acquirer than its face value would suggest?
- A stock deal creates a $180M DTL (from $720M of combined write-ups, 25% tax rate). The same target, if acquired in an asset deal, would generate no DTL but goodwill would instead be $180M lower and tax-deductible over 15 years. Compute the annual cash tax shield from the asset-deal goodwill amortization if total goodwill in that scenario is $1,050M, and explain which structure a financial buyer paying an identical enterprise value would prefer, and why a seller might resist it.
- A target carries a $500M NOL. At the ownership change its equity value is $1,800M and the applicable long-term tax-exempt rate is 4.5%. Compute the annual Section 382 limitation, determine how many years it would take to fully utilize the NOL absent any expiration, and explain how a valuation allowance would change your DTA recognition if you believed only 60% of the NOL would ultimately be used before expiring.
- In a stock deal, PP&E is written up $250M and new intangibles of $650M are recognized, tax rate 25%. Compute the DTL, then compute the year-one DTL reversal assuming the PP&E write-up depreciates over 10 years and the intangibles amortize over 8 years. Explain precisely where this year-one reversal appears in unlevered free cash flow versus levered free cash flow.
- A private-equity buyer is acquiring an S-corp target and can freely elect 338(h)(10) treatment without triggering the classic 'double tax' problem that a C-corp seller would face. Explain why this structural fact makes the step-up election far more likely to be used here than in a large public company stock-for-stock merger, and quantify (in general terms) what changes in the goodwill build and the acquirer's post-close cash taxes.
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Keep going
- What happens to the target's existing goodwill and its historical equity accounts on the pro forma balance sheet, and why?
- Explain why the target's historical equity accounts are eliminated on the pro forma balance sheet rather than combined with the acquirer's.
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The rest of this topic
Purchase accounting: goodwill, write-ups and the tax basis