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.
At the time these rules were created, FASB was beseeched to create an exception to the requirement that taxable temporary differences always result in DTLs, based on this variety of taxable temporary difference. But FASB chose to eschew such an exception as inconsistent with its overarching goal of comprehensive deferred tax accounting.
Nevertheless, through the years, the agencies that regulate banking organizations have received requests from their constituents to permit the amount of goodwill arising from a taxable business combination that must be deducted from Tier 1 capital to be reduced by any associated DTL. What’s more, the agencies have now heeded this request.
This change of heart stems from the realization that Tier 1 capital should only be reduced by the organization’s “maximum exposure to loss if the goodwill becomes impaired or is derecognized under generally accepted accounting principles (GAAP)”. If the goodwill became impaired (or was otherwise required to be derecognized under GAAP), the difference between the amortized tax basis of the asset and its carrying amount would narrow or disappear. Consequently, associated DTL would be reduced or eliminated.
Accordingly, the maximum regulatory capital reduction that could occur as a result of the impairment of goodwill is the gross carrying amount, less any associated DTL. Recognizing this fact, the notice of proposed rulemaking provides, in effect, that a banking organization will be permitted to increase its Tier 1 capital by an amount equal to the DTL associated with the goodwill arising in a taxable business combination.
This seems to be, in our judgment, an eminently sensible decision. It will have the salubrious effect of reducing the regulatory capital deduction for goodwill to an amount that’s equal to the maximum regulatory capital reduction that could occur as a result of the goodwill. Again, the goodwill in this case would arise from a taxable business combination, and become completely impaired or otherwise derecognized. Clearly, the charge to capital should not exceed the amount of the loss the banking organization would experience if it found the goodwill worthless — an outcome which the notice of proposed rulemaking, should it be adopted, will ensure.
1A taxable business combination is a business combination that is structured as an acquisition of a target’s assets, including an acquisition of such target’s stock where the stock acquisition, constituting a “qualified stock purchase,” is accompanied by an election under Section 338(g) of the Internal Revenue Code. In the case of a taxable business combination, the fair market value of the acquired assets becomes the new bases of such assets. In a taxable business combination, the purchase price is allocated to the acquired assets and liabilities in order to derive the bases of these items.
2 See FAS No. 142, supra; an entity is required to recognize deferred taxes relating to goodwill when amortization of such goodwill is deductible for tax purposes.