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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