Recently, the Federal Reserve Board requested public comments on an interagency notice of proposed rulemaking that would alter the manner in which a banking organization, under the Fed’s jurisdiction, calculates a crucial measure of financial health — so-called Tier 1 capital. In most cases, this class of capital refers to core holdings, including equity and disclosed reserves.
Under existing regulatory capital rules, a banking organization must deduct certain assets from Tier 1 capital. Included among these assets are goodwill and other intangible assets arising from a “taxable business combination.”
The full or “gross carrying amount” of the asset is deducted for purposes of determining Tier 1 capital. By contrast, and inexplicably, a banking organization when computing Tier 1 capital is permitted to net any associated deferred tax liability (DTL) against some intangible assets acquired in a non-taxable business combination prior to deduction from Tier 1 capital. The notice of proposed rulemaking is designed to eliminate this dichotomy with respect to goodwill (and presumably other “indefinite lived” intangible assets) arising in a taxable business combination. 1
In the case of a taxable business combination, FAS No. 141, Business Combinations, requires the use of the “purchase method” of accounting. (For business combinations completed in 2009 and later, the “acquisition method” of accounting will have to be employed). Under the purchase method, however, the acquiring entity is required to assign the cost of the acquired entity to each identifiable asset acquired and liability assumed.
The amounts so assigned are based upon the fair market values of these items as of the “acquisition date.” In cases where the cost of the acquired entity exceeds the net of the amounts so assigned, the excess is attributed to goodwill. In a taxable business combination, the carrying amount and tax basis of goodwill are initially identical with the result that no DTL (or deferred tax asset) is established to reflect the tax effect of any basis difference.
However, for financial accounting purposes, FAS No. 142, Goodwill and Other Intangible Assets, prohibits the amortization of goodwill and requires instead the periodic “testing” (not less frequently than annually) of the carrying amount of goodwill for impairment. By contrast, for tax purposes, Section 197(a) of the Internal Revenue Code requires that the cost of most acquired intangible assets, including goodwill, be amortized ratably over the 15 year period beginning with the month in which the intangible asset is acquired.
Taxable Temporary Differences
As a result of this difference in treatment, so-called “taxable temporary differences” will arise as goodwill is amortized for tax purposes, but not for “book” purposes. Such disparate treatment will create an excess of book basis over tax basis with respect to the asset. As a result, a taxable temporary difference would be created within the meaning of FAS No. 109, Accounting for Income Taxes, with respect to which a DTL must be recognized.2
The DTL, however, is neither reduced nor reversed (i.e, it is not “settled”) for financial reporting purposes unless the associated goodwill is written down (or written off) upon finding an impairment, or is otherwise “derecognized.” Therefore, the DTL will not be settled until some indefinite future date.