A Makeover for Uncertain Tax Positions
In an effort to curb the growing number of diverse accounting practices companies are using to analyze and report their tax positions, the Financial Accounting Standards Board (FASB) recently enacted FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes. It is effective for all U.S. GAAP financial reporting enterprises, including pass-through and not-for-profit entities, for tax years beginning after December 15, 2006. Since many areas of tax law are complex, voluminous, and ambiguous, companies quantify many tax positions to a large extent by subjective decision-making, and to a lesser extent by substantive evidence and case law. FIN 48 applies guidelines in addressing uncertain tax positions to bring more relevance and comparability to the financial reporting of income taxes in accordance with FAS 109.
It is important to note that tax positions governed under FIN 48 are not limited to income tax positions taken on an income tax return. For example, the decision to not file a tax return, state income tax allocation and apportionment methodology, and reasons to exclude certain items from taxable income fall under FIN 48. Taxes not substantially measured by net income, e.g., sales and use taxes, VAT, GST, franchise taxes based on net worth, the Michigan SBT, and state filing fee or minimum taxes to name a few, are excluded.
How is FIN 48 Applied?
The heart of FIN 48 introduces a two-step process, recognition and measurement, that a company must apply to all tax positions they claim, based on the relevant facts and evidence.
In assessing the recognition of a tax position, a company must adhere to the following general parameters:
- It must be more likely than not, i.e., greater than 50%, that a tax position the company takes will be sustained upon examination by a taxing authority or appeals process.
- There is a presumption that every tax position will be examined, and that all documentation, knowledge, and support related to that position will be available to the examining authority.
- The technical merits of a tax position must be derived from appropriate authoritative bodies and their related statutes, case laws, regulations, or rulings.
If the "more likely than not" element is not satisfied, then a company must derecognize that tax position and report its effects in the next subsequent reporting period of its financial statements, including potential interest and penalties based on statutory rates and regulations. For calendar year public companies this would include the first quarter 2007 to report the effects of tax position changes. Note that changing the valuation allowance as a means to adjust a tax position is insufficient.
The measurement process is applied only after satisfying the "more likely than not" element. Measurement determines what amount of a tax position will be sustainable upon a potential examination or settlement. If upon measuring, the tax effect produces a range, the company may claim the highest tax benefit from that range as long as it is over 50 percent likely of being realized using a probability analysis.
Financial Statement Disclosure
As expected, there will be thorough disclosure required to comply with FIN 48. This includes footnote disclosure on the date of its adoption, specific tax areas, or events affected, disclosing a tabular schedule showing the unrecognized tax benefits from any FIN 48 adjustments, and reporting accrued interest and penalties on such adjustments if applicable. It is uncertain at this time if FIN 48 work papers are privileged under section 7525 of the Internal Revenue Code or if an agent can request the work papers upon audit.
In short, FIN 48 brings the reporting of tax positions to a much higher level with respect to how they are analyzed, documented, reported, and disclosed. While management’s judgment will still play a part in the process, it is relegated to a level that gives more weight to the evidence, thus giving more relevance to the tax position the company claims while minimizing risk upon examination.
ABC Company is evaluating its tax position on the R&D credit claimed on its prior year federal corporate income tax return. After analyzing the evidence and facts, management determined that the $1 million credit originally reported was overstated and likely would not be fully recognized upon a potential examination or audit.
Management conducts a probability analysis based on the evidence collected to determine the highest amount of the R&D credit available that is more likely than not (>50%) of being sustained upon potential audit or examination.
|Possible Benefit Outcome Upon Audit Settlement||Individual Probability % of Successful Outcome||Cumulative % of Successful Outcome|
|$1 million R&D credit||5%||5%|
|$800k R&D credit||20%||25%|
|$600k R&D credit||30%||55%|
|$400k R&D credit||25%||80%|
|$200K R&D credit||20%||100%|
Based on the above analysis, $600k is the highest credit amount with a greater than 50% chance of being sustained. Therefore, the company must record the tax liability impact ($400k plus penalty and interest) within a newly established FIN 48 liability account with the corresponding entry to retained earnings. The gross FIN 48 liability is disclosed in a new footnote with appropriate explanations and a tabular rollforward schedule.