Impairment of goodwill and its fiscal treatment: more trouble for the Portuguese firms and tax courts?

• Author: Martins, Antonio
• Position: Report

1. INTRODUCTION

   The progressive generalization of the International Financial Reporting Standards (IFRS) across the world has many important consequences as far as the quality of financial information is concerned.(Cole at al, 2010). In this context, the role performed by auditors has been a particular area of research, given the influence of auditing in the perceived quality of financial information. (Kusuma and Nurim, 2010; Lennox and Pittman, 2010).

   Given the usual link between corporate taxable income and book income in many continental European tax systems, the introduction of IFRS can increase or decrease the level of book-tax alignment in countries where previous national accounting systems are converted to new IFRS based models.

   In some countries, such as the USA, research on the potential tax effects of accounting choices is well documented. (Shaviro, 2009; Desaiand Dharmapala, 2009).In Portugal the financial accounting system was adapted to IFRS in 2010. As new elements, such as fair value gains and losses or impairment charges, were introduced in the computation of net income, tax legislators had to react, adapting the corporate income tax code (CITC). Changes in the code were, mainly, related to the tax treatment of new types of revenues and expenses: would they be relevant for the determination of taxable income? More specifically, if, for example, accounting charges such as impairment of assets, which diminish book income, were recognized, should they be allowed in the determination of taxable income? Or, on the contrary, should tax rules disqualify these charges in the computation of taxable income, therefore increasing the divergence between book and tax variables.

   The purpose of this paper is to analyze how the new Portuguese accounting-tax system treats the impairment charges in recognized goodwill after acquisitions by buying firms. To the best of my knowledge, this is an area where economic and legal based research has not been done in Portugal regarding the impact of new solutions in litigation potential. And, given the fiscal treatment of goodwill impairment charges and the potential for litigation it entails, it is a relevant topic for discussion. As I will show latter, there are two sources of potential (and costly) litigation concerning the tax treatment of good will impairment charges in Portugal: one based on economic grounds, and the other based on legal reasons.

   This paper thus adds to the literature that explores the corporate impact of legal tax changes, especially induced lawsuits derived from divergent interests of taxpayers and tax administration. To analyze the issue, the paper is organized as follows: section 2. Deals briefly with the economic basis for recognizing goodwill in acquisitions; section 3. analyses its accounting and fiscal treatment in Portugal by comparing them with the previous one (before IFRS introduction in 2010); section 4. analyses the economic and legal reasons why the tax treatment of goodwill impairment can be a source of litigation to increase the troubles of the, already overburdened, tax courts; section 5 concludes.

2. THE ECONOMIC BASIS FOR RECOGNIZING GOODWILL AND ITS SUBSEQUENT TREATMENT

   Acquisitions are a regular feature of corporate strategy (Weston et al, 1998).In most acquisitions, goodwill often arises and must be recognized in financial statements. As it is well known, the arithmetic definition of goodwill is the difference between the price paid by the acquirer and the fair value of the net assets of the target firm. From an economic or substantial perspective, goodwill comes from the excess returns that the acquiring entity expects to extract from the acquisition. (Neves, 2002; Gu and Lev, 2008)

   The foundation for this expectation of the acquiring firm usually rests on some factors: the acquirer better management capacity will make the target's assets more profitable; the more intensive use of competitive advantages that the target has developed but has no resources to apply in a profitable manner, and the synergies that cost reductions, product combinations another profit enhancing measures will provide. (Damodaran, 2001)

   Thus, viewed from an economic perspective, goodwill is a "promise", an objective, that the acquiring management presents to its shareholders. In short, it is as if managers said: "give us your permission to buy, and we can use the target's assets to make you richer". In the meantime, the price eventually paid above fair value is justified by these expected supra normal returns.

   Given this rationale for acquisitions, and the economic logic behind goodwill recognition, what has the empirical financial literature found about post acquisitions results for shareholders?

   A vast literature (summarized, among others, by Ross et al, 2002) shows that the shareholders of the target entity gain, on average, 20% to 30%. The acquiring companies usually show null or very modest gains for their shareholders, following acquisitions.

   The hubris hypothesis is put forward by many authors to explain these results for acquirers. Managers are more interested in expanding empires than to a rational assessment of targets' real potential in...