Tax Indemnification and Unrecognized Tax Benefits in Mergers and Acquisitions

Tax indemnification transfers the risk of potential tax settlements from a taxpayer to an external party. Current accounting standards require firms to reflect unrecognized tax benefits (UTBs) even when the underlying tax position has indemnification. Practitioners suggest that financial statement disclosures regarding tax indemnification are necessary to allow users to assess tax risk adequately. However, acquirers rarely disclose tax indemnification arrangements from merger and acquisition (M&A) contracts. Evidence suggests that tax indemnification attenuates the positive association between UTBs and future tax cash outflows. Moreover, results are consistent with indemnification agreements resulting in minimal settlements. Because of the effect that removing accounts associated with lapsed indemnification agreements has on effective tax rates and the attenuating effect that indemnification has on UTB's association with future tax cash outflows, the findings could be of interest to the Financial Accounting Standards Board regarding their income tax disclosure project.