Deferred Tax on Fair Value Adjustments in Business Combinations

Question

P Limited acquired 100% equity shares of S Limited on 1st April 2025 for a purchase consideration of Rs. 1,500 lakhs. The acquisition qualifies as a business combination and is accounted for in accordance with Ind AS 103, Business Combinations. As part of the purchase price allocation exercise, P Limited determined the fair values of the identifiable assets acquired and liabilities assumed as follows:

Further, assume the following:

The tax bases of the assets and liabilities remain unchanged after the acquisition.

The applicable income tax rate is 30%.

It is probable that sufficient future taxable profits will be available to utilise any deductible temporary differences arising on acquisition.

P Limited seeks guidance on whether deferred tax is required to be recognised on the acquisition date and, if so, how such deferred tax affects the computation of goodwill.

Relevant Provisions

Ind AS 12, Income Taxes

Para19:With limited exceptions, the identifiable assets acquired and liabilities assumed in a business combination are recognised at their fair values at the acquisition date. Temporary differences arise when the tax bases of the identifiable assets acquired and liabilities assumed are not affected by the business combination or are affected differently. For example, when the carrying amount of an asset is increased to fair value but the tax base of the asset remains at cost to the previous owner, a taxable temporary difference arises which results in a deferred tax liability. The resulting deferred tax liability affects goodwill (see paragraph 66).

Para 24: A deferred tax asset shall be recognised for all deductible temporary differences to the extent that it is probable that taxable profit will be available against which the deductible temporary difference can be utilised, unless the deferred tax asset arises from the initial recognition of an asset or liability in a transaction that:

(a) is not a business combination; 1a[***]

(b) at the time of the transaction, affects neither accounting profit nor taxable profit (tax loss); and

(c) at the time of the transaction, does not give rise to equal taxable and deductible temporary differences.]

However, for deductible temporary differences associated with investments in subsidiaries, branches and associates, and interests in joint arrangements, a deferred tax asset shall be recognised in accordance with paragraph 44.

Para 26(c ):The following are examples of deductible temporary differences that result in deferred tax assets: with limited exceptions, an entity recognises the identifiable assets acquired and liabilities assumed in a business combination at their fair values at the acquisition date. When a liability assumed is recognized at the acquisition date but the related costs are not deducted in determining taxable profits until a later period, a deductible temporary difference arises which results in a deferred tax asset. A deferred tax asset also arises when the fair value of an identifiable asset acquired is less than its tax base. In both cases, the resulting deferred tax asset affects goodwill (see paragraph 66); and

Para66: As explained in paragraphs 19 and 26(c), temporary differences may arise in a business combination. In accordance with Ind AS 103, an entity recognises any resulting deferred tax assets (to the extent that they meet the recognition criteria in paragraph 24) or deferred tax liabilities as identifiable assets and liabilities at the acquisition date. Consequently, those deferred tax assets and deferred tax liabilities affect the amount of goodwill or the bargain purchase gain the entity recognises. However, in accordance with paragraph 15(a), an entity does not recognise deferred tax liabilities arising from the initial recognition of goodwill.

Para 47: Deferred tax assets and liabilities shall be measured at the tax rates that are expected to apply to the period when the asset is realised or the liability is settled, based on tax rates (and tax laws) that have been enacted or substantively enacted by the end of the reporting period.

Analysis

To determine whether deferred tax arises on the acquisition date and assess its impact on goodwill, P Limited must evaluate the temporary differences created by the fair value adjustments recognised in the business combination. The analysis is as follows:

(a) Under Ind AS 103, the identifiable assets acquired and liabilities assumed are recognised at their fair values on the acquisition date. However, their tax bases generally remain unchanged. As a result, temporary differences arise between the carrying amounts and tax bases, which will reverse in future periods.

(b) Plant & Machinery is recognised at a fair value of Rs. 500 lakhs, while its tax base remains Rs. 400 lakhs. This gives rise to a taxable temporary difference of Rs. 100 lakhs.

(c) Land is recognised at a fair value of Rs. 420 lakhs, whereas its tax base remains Rs. 300 lakhs. Accordingly, a taxable temporary difference of Rs. 120 lakhs arises.

(d) Inventory is recognised at a fair value of Rs. 180 lakhs, while its tax base remains ₹150 lakhs, resulting in a taxable temporary difference of Rs. 30 lakhs.

(e) The warranty provision is recognised at Rs. 90 lakhs, whereas its tax base remains ₹60 lakhs because the related expenditure will generally be deductible only when incurred. This gives rise to a deductible temporary difference of Rs. 30 lakhs.

(f) The carrying amounts and tax bases of trade receivables and trade payables are equal. Therefore, no temporary differences arise in respect of these items.

Accordingly, the business combination gives rise to taxable temporary differences of Rs. 250 lakhs (Rs. 100 lakhs + Rs. 120 lakhs + Rs. 30 lakhs) and a deductible temporary difference of Rs. 30 lakhs. Applying the tax rate of 30%, the deferred tax liability amounts to Rs. 75 lakhs (Rs. 250 lakhs × 30%), while the deferred tax asset amounts to Rs. 9 lakhs (Rs. 30 lakhs × 30%). Assuming sufficient future taxable profits will be available, the deferred tax asset qualifies for recognition. Therefore, P Limited is required to recognise a net deferred tax liability of Rs. 66 lakhs (Rs. 75 lakhs − Rs. 9 lakhs) on the acquisition date.

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