Why Deferred Tax Liabilities Get Created in an M&A Deal

okay hello and welcome to another financial modelling tutorial this time around we're going to be talking about a very specific topic that comes up in mergers and acquisitions which is as you can see up here why deferred tax liabilities get created in these deals let's go away from our simple Excel model for a second and just go over here and sort of go through why this matters in the first place and then a couple of real-life examples of where these items get created so deferred tax liabilities are part of the purchase price allocation in any M&A deal so here's a quick example I'm going to pull up this excel file that we have for United and Goodrich which is a major deal in the aerospace and defense industry and if you go to the purchase price allocation schedule here you can see that they have this new item deferred tax liability and over here it's being calculated and it's being it's set equal to the total of the PPE right up and then the intangibles write-up times the buyers tax rate so that's how that's being calculated here and what goes on here is that in the purchase price allocation process most the items are going to retain their same value in the balance sheet but some of them are going to change to the ones that change the most frequently are PPE and intangibles the values written up sometimes is written down but it changes in some way when that happens the companies defer tax line items change now this is not just something theoretical if you go to Oracle's filings for example they're a very acquisitive company which is why I picked them take a look at their filings in a year and they'll say something like 244 million of net tangible liabilities related primarily to deferred tax liabilities over here so they're going through their historical deals and they're actually saying you know what we created 244 million of deferred tax liabilities for this deal and if you go down you can see that they have other references to it so sometimes they group it together with performance obligations convertible debt other things but they always has some reference to it when they talk about their acquisitions and if you scroll down further you can see that actually look at this for their deferred tax liabilities they actually break it out by category and they have a category here for acquired intangible assets so there are saying you know what a lot of these are related to acquisitions and so it comes up in real life all the time especially for a highly acquisitive company like oracle the fact these yet created what does this have to do with in the first place well it really reflects the timing differences between when a company records taxes on its publicly filed income statement ins filings and then what it actually pays those taxes and specifically what happens here is that oftentimes in M&A deal a buyer will increase the value of the sellers PP&E and other intangible assets under the argument that the fair market value is higher than what's on their company's balance sheet but when it does that just like how you normally depreciate PPT and how you normally amortize intangible assets you also have to depreciate or amortize these write-ups but the catch is that you only do that on the book version of the company's statements now this depends a little bit on the deal tip so we're going to skip over that in this tutorial but in most common deal tips involving public companies you can only do this on the book version of the company statements you cannot do it on the actual tax schedule that they use when they're paying taxes to the government so that's what creates this difference and what ultimately creates this deferred tax liability now this doesn't make a huge outcome in the end on a merger model or an M&A analysis in most cases but there are a few important points to realize about this anyway first off it's common to get interview questions on these topics maybe not defer tax liabilities exactly but they can certainly ask about purchase price allocation or you also need to know this if you are working with a more advanced analysis so if you're looking at M&A deal where taxes are very important for example you need to know this and then finally it's a very common point of confusion and I think the two most common questions we have in this topic are number one wait a minute why does a deferred tax liability get created immediately in an M&A deal isn't it caused by differences over time or isn't it caused by different depreciation rates or different depreciation schedules why does it happen right away and then number two wait a minute so you just said that depreciation is recorded for these write-ups on the book version of a company's income statement but not on the tax version that means that the taxable income on the book version of their statements is lower than it is on the cash version of their statements doesn't that create a deferred tax asset and so these are two common points of confusion and to clarify them here's what I would do instead of thinking about a company's taxable income or its historical situation you want to think about its future taxes so in this example over here we'll get into this in a bit but we're not dealing with anything that happened historically your 1 through year 10 these are all future years and the company's future taxes that are going to be paid now this deferred tax liability that gets created in the beginning equal to intangibles created plus the PP me write up times the tax rate well yes this gets created where right away but this gets created because there will be differences in the future so that's the first thing you need to understand about how this works and how it works I've sort of outlined over here which is that if future cash taxes exceed future book taxes you get a deferred tax liability and the reason you get this is because you have to pay additional taxes because many of those items that you're saying our tax deductible are not in fact tax-deductible namely the depreciation and amortization on these write-ups so you're paying more in taxes then your income statement would imply and that's why you get a DTL now if the opposite happens if future cash taxes are less than future book taxes a deferred tax assets you are paying less in taxes then the company's book income statement implies and that's how it works now over time these tax payments will equalize they'll normalize they even out and so the DTL or DTA goes away and that's how it works here so instead of thinking about taxable income or historical taxes or anything like that think about what happens in the future and if you're paying more than what your income statement implies you have a DTL that gets created if you are paying less than what your income statement implies and taxes then you get a dta that gets created so here's an example and I'm going to scroll over here and show you an excel what happens to a deferred tax liability over time so in this case we have a company's operating income going from 100 to 170 and I can actually change this around a little bit so 180 190 over there so we have a going up by around ten each year now what happens here is that we have a write-up for the intangibles and ppso an M&A deal just happened and this is the combined company's operating income after the fact we're assuming they have no interest expense no other items so operating income effectively is pre-tax income here tax rate is 40 percent and what happens is that this intangible write-up of 85 million gets amortized over five years that's the standard period for the SEPA thing the PPD write-up so you're adjusting the value of factories or buildings or land or something like that you're just going up by twenty four million this gets depreciating over eight years so maybe this is the average useful life of a company's assets now what's important here is that these are both non-cash expenses and you're reflecting these expenses you're allocating these expenses over time so let's first take a look what happens on the company's book version of its statements this is what you would see and it's publicly listed filings and its income statement in its SEC filings your annual report for companies outside the US so operating comes 100 to 110 under 20 going up to 190 and they deduct the amortization of intangibles here you often see this as an expense on a company's income statement they also deduct the depreciation of the PPT right up normally this is grouped together with other depreciation but this is also an item and so the book taxable income falls by a good amount by about 20 million in the first five years and then after that the amortization goes away but the depreciation remains about three million per year so the taxable income is about three million lower than the companies operating up now book taxes you just take this book taxable income you multiply by the tackier to 40% to get that number in each year so that's what the company's public statements look like but let's look at its tax schedule now so here it's pretty simple we have a tax operate income going from 100 to 190 again but we cannot deduct the amortization of intangibles we cannot deduct the depreciation of this PP near item so what happens here well the cash taxable income ends up being significantly higher than the book taxable income especially in the first five years and so the cash taxes look at this are much higher than the book taxes especially in the first five years so what happens here well we have a situation where the cash taxes exceed the book taxes because of these items we cannot actually deduct for true tax filing purposes and so what happens here is that our deferred tax liability it's going to start out at forty four and then each year it's going to decrease by the difference between the cash taxes and the book taxes so we take our starting number and then we take our book taxes over here we subtract our cash taxes so that if the cash taxes are higher this is going to decrease if the cash taxes are lower this is going to increase so we have that and it goes down by eight million in the first year and then we can actually just copy all this all the way over and take a look at this so by year five this is already down to four million and then after that it goes down to zero pretty quickly by year eight which is the last year of the depreciation of this PPT right up the deferred tax liability is zero and then in the next two years after that it stays at zero and it goes away completely why because take a look at this our taxes sixty-seven 72 76 68 72 76 by the last few years of this period there either almost the same or the same in the last two years and that's why the deferred tax liability goes away completely so that's how to think about and that's a real life example of what happened of course these are simple numbers but this illustrates the concept very well so going back to this Oracle example when they tell you something like two hundred forty four million of deferred tax liabilities as they have listed right here there's not going to stick around forever those are going to go away over time as the companies booked taxes and cash taxes even even out and you can actually see evidence of this on some of their statements because take a look at this they have deferred tax liabilities related to acquired assets and look at this it's decreased it's gone down by about 200 million from year to year so in general these will tend to decrease over time as the difference in book taxes and cash taxes normalizes now of course if there's another acquisition these video up again and with Oracle there frequently is so you have to keep that in mind as well but this is what happens for a single acquisition so that's really it for our lesson now to go back to those original questions why does a detail get kradin immediately isn't it created by the book and cash acts as being in a sovereignty over a certain period answer is no not necessarily it can be a cause that can be a cause of this but they can also be created by events that change a company's future tax situation so it's not about past taxes it's not about taxable income it's about how future taxes change and if that happens because of a single event then these get created at a single time and then they change over time as taxes even out and then the second question wait a minute the taxable income for book purposes is lower than it is for tax purposes doesn't that create a deferred tax asset nope because the relevant question is not the taxable income and how that differs but how the future taxes themselves will differ and so if the company pays more and cash taxes than book taxes in the future as a result of these write-ups or any other changes then the deferred tax liability gets creighton if it's the opposite deferred tax assets created so that's it for this lesson just to recap this important because these come up in any M&A deal you'll see them frequently in purchase price allocation schedules they reflect timing differences and specifically when a buyer writes up PP&E or other intangible assets it cannot deduct depreciation and amortization on that for tax purposes but it will list out on its income statement and effectively as a result of that it ends up paying more in taxes in cash terms than its income statement implies and that's what creates this you saw how it worked in our Excel schedule earlier so now that you understand this concept what do you do next we'll keep it in mind for interviews very common question even in entry-level interviews and the next time you see a deal announced do what we did go and look up the company's filings but one see if you can find a reference to it and then go and do your own back of the envelope estimate say ok let's make some assumptions let's see what the deferred tax liability comes out to and then let's see based on the buyer's tax rate and the percentage is the amounts here how it will change over time and that will give you some additional practice that you can use to understand this concept you

Channel: Mergers & Inquisitions / Breaking Into Wall Street

Views: 55,094

Keywords: Fixed Asset Write-Ups, Deferred Taxes, Cash Taxes, deferred tax liability, deferred tax, M&A, Deferred Tax Liabilities, Purchase Price Allocation, Book Taxes, deferred tax assets and liabilities, deferred tax asset, Book vs. Cash Taxes, deferred tax assets, m&a deals, DTL, Merger Models, Mergers & Acquisitions, Fair Market Value, Balance Sheet Adjustments, Other Intangible Assets, Depreciation, Depreciation & Amortization, Mergers And Acquisitions, Breaking Into Wall Street

Id: UpbxN_xuGV4

Length: 13min 24sec (804 seconds)

Published: Tue Mar 18 2014