FIN 48 Accounting for Uncertainty in Tax Positions

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FIN 48 Accounting for Uncertainty in Tax
Positions

• May 12, 2008

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Course Outline

• Background/Basic Concepts
• Recognition and Measurement
• Special Rules
• Examples
• Financial Statement Disclosures

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FIN 48 Basic Concepts
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Uncertain Tax Positions FIN 48Why the Change?

• Diversity in practice of how tax positions were
  recognized in financial statements
• FAS 109 did not address this issue
• Some of the practices included
• Recording a cushion for the estimated liability
  resulting from final resolution of the
  uncertainty
• Increasing the valuation allowance to reduce
  deferred tax assets for the estimated effect of
  the uncertainty
• Establishing a confidence threshold for
  recognizing tax benefits and applying the FAS 5
  probable threshold for recording contingent
  losses associated with those positions

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Uncertain Tax Positions FIN 48Effective Date
and Transition

• FIN 48 is effective for fiscal year beginning
  after December 15, 2007
• Early adoption permitted if company has not
  issued interim financial statements for the year
• These rules must be applied to all open tax
  positions upon initial adoption
• The cumulative effect of adopting FIN 48 is
  recognized as an adjustment to beginning retained
  earnings
• SAB 74 disclosures regarding estimated future
  impact is required for all financial statements
  issued by public companies before adoption of FIN
  48

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Uncertain Tax Positions FIN 48What is a Tax
Position?

• FIN 48 applies to all tax positions accounted for
  under FAS 109, including (but not limited to)
• Position in a previously filed tax return or
  expected filing position that effects current or
  deferred tax assets or liabilities for interim or
  annual period
• A decision whether or not to file a tax return
• A decision to exclude reporting income in a tax
  return
• Characterization of gains or losses as capital or
  ordinary
• Allocations of income between taxing
  jurisdictions
• Decisions to classify transactions or entities as
  tax exempt

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Uncertain Tax Positions FIN 48Scope

• FIN 48 applies to income taxes only and does not
  apply to non-income taxes such as property taxes,
  sales use taxes, franchise taxes based on
  capital, etc.
• On the other hand, FIN 48 has heightened the
  awareness as to liabilities for these other taxes
  which are still subject to FAS 5
• FIN 48 applies to any entity that is potentially
  subject to income taxes, including
• Nonprofit organizations
• Flow-through entities (i.e., partnerships, S
  corporations, LLCs)
• Pass-through entities with 100 credit for
  dividends paid such as REITs and RICs

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FIN 48 Recognition and Measurement
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Uncertain Tax Positions FIN 48Step 1 -
Recognition

• Criteria for financial statement recognition of a
  tax position
• More likely than not (more than 50) the position
  will be sustained upon examination (including
  appeals or litigation required to settle the
  matter)
• Based on the technical merits of the position
• Presume examination by relevant taxing
  authorities that have full knowledge of all
  relevant information (i.e., no audit lottery)
• Evaluate each position without offset or
  aggregation

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Uncertain Tax Positions FIN 48Step 1 -
Recognition

• Technical merits are based on
• Application of sources of tax law authority to
  facts and circumstances
• Includes legislation and statutes, legislative
  intent, regulations, rulings and case law
• Highly recommended that auditors utilize tax
  professionals to examine and evaluate technical
  merits of tax positions
• May rely on widely understood administrative
  practices and precedents of taxing authority in
  dealing with similar businesses
• (e.g., fixed asset capitalization threshold)
• This exception should only be used when there is
  compelling evidence the taxing authority will
  accept the position

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Uncertain Tax Positions FIN 48Step 1 -
Recognition

• Unit of account must be used to determine if more
  likely than not (MLTN) threshold is met
• Based on how taxpayer prepares and supports tax
  return
• Based on the approach anticipated to be taken by
  examining tax authorities
• The unit of account can change based on a change
  in facts and circumstances
• Example unit of account for RD credit may be
  projects or departments

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Uncertain Tax Positions FIN 48Step - 2 -
Measurement

• Measurement determining the largest amount of
  tax benefit greater than 50 likely to be
  realized upon settlement
• Based on expected negotiated settlement with
  taxing authority that has access to all relevant
  facts
• Based on managements best judgment given the
  facts, circumstances and information available at
  the time

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Uncertain Tax Positions FIN 48Measurement

• Example

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Uncertain Tax Positions FIN 48Subsequent
Recognition/Derecognition

• If MLTN threshold not initially met, tax benefit
  recognized in first interim period that meets one
  of these conditions
• The MLTN threshold is met
• The tax matter is resolved through settlement or
  litigation
• The statute of limitations has expired
• A previously recognized tax position is
  derecognized when it is no longer more likely
  than not that the position will be sustained
• Use of valuation allowance is not permitted for
  this purpose

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Uncertain Tax Positions FIN 48Change in
Judgment

• Change in judgment based on new information can
  result in recognition, derecognition or change in
  measurement
• Recognized as a discrete item in earnings in the
  period in which the change occurs and does not
  affect the estimated annual effective tax rate
• If change occurs in different interim period of
  the same fiscal year as initial recognition, then
  it is reflected in the estimated annual effective
  tax rate

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FIN 48 Other Special Rules
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Uncertain Tax Positions FIN 48Interest and
Penalties

• Interest on underpayments should be recorded in
  the first interim period that interest would
  begin accruing by applying the statutory interest
  rate to the difference between tax position
  recognized in the financial statements and the
  amount claimed on the tax return.
• If a tax position does not meet the minimum
  threshold to avoid penalties, an expense must be
  recognized in the period the company expects to
  claim the position in the tax return.

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Uncertain Tax Positions FIN 48Deferred Tax
Impact

• FIN 48 applies to temporary differences as well
  as permanent differences
• Computation of temporary differences are based
  upon tax effect of MLTN tax basis versus
  financial statement basis of assets and
  liabilities
• The tax effect of difference between MLTN tax
  basis and as filed tax basis should be recorded
  as a reserve in income taxes payable

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Uncertain Tax Positions FIN 48Classification
of Liability

• Liabilities arising from the difference between
  the tax treatment and the financial statement
  measurement of the tax benefit is recorded based
  upon expected cash payment
• Payable within one year or operating cycle -
  current tax payable
• Payable in excess of one year - non-current tax
  payable

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Uncertain Tax Positions FIN 48Classification
of Liability

• Interest and penalties may be classified as
  either income tax expense or interest expense
  based on accounting policy elected by management
• If interest is classified as income tax expense,
  the interest will need to be recorded net of the
  tax benefit, since the interest is tax deductible

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FIN 48 - Examples
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Uncertain Tax Positions FIN 48Example
Permanent Difference

• Research credit claimed on return 1,000,000
• Unit of account 4 projects at 250,000 each
• Projects 1,2,3 meet MLTN threshold, project 4
  does not
• Potential recognition 250,000 x 3 750,000
• Largest settlement more than 50 likely is
  250,000 for project 1 and 200,000 each for
  projects 2 and 3
• Initial measurement 250,000200,000200,000
  650,000

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Uncertain Tax Positions FIN 48Example
Permanent Difference

• Journal entry to record uncertain tax position
  benefit
• Current tax receivable 1,000,000 Current
  income tax expense 650,000 Non-current
  income tax payable 350,000
• Assume the credit is later settled at 700,000,
  the entry would be as follows
• Non-current income tax payable
  350,000 Current income tax expense
  50,000 Cash (payment to IRS) 300,000

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Uncertain Tax Positions FIN 48Example
Taxable Temporary Difference

• Acquired intangible asset of 150,000
• Indefinite book life
• Tax return filing position entire cost
  deductible in year 1
• 40 likely to sustain immediate deduction 60
  likely to obtain sec 197 15 year amortization
• Largest settlement more than 50 is 15 year
  amortization
• Initial measurement in Year 1 150,000 / 15
  10,000 x 40 4,000
• Additional benefits in years 2-15 of 4,000 per
  year

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Uncertain Tax Positions FIN 48Example
Taxable Temporary Difference

• At end of Year 1 record deferred tax liability
  for difference between book basis and the MLTN
  recognized tax basis (150,000 10,000
  140,000)
• 150,000 140,000 10,000 x 40 4,000
• The company will still claim a 150,000 deduction
  on the tax return, so they will need to record a
  current tax receivable of 60,000
• Where does the difference of 56,000 go to
  balance the entry?

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Uncertain Tax Positions FIN 48Example
Taxable Temporary Difference

• Journal entry to record uncertain tax position
  benefit
• Current taxes receivable 60,000Deferred tax
  expense 4,000 Non- Current tax
  liability 56,000 Deferred tax liability
  4,000
• Current tax benefit 4,000
• In year two, the entries would be as follows
• Non-current tax liability (reserve) 4,000Deferr
  ed tax expense 4,000 Current tax benefit
  4,000 Deferred tax liability 4,000

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Uncertain Tax Positions FIN 48Example
Taxable Temporary Difference

• Assume the issue is settled with the IRS after
  Year Five and the IRS prevails and requires 15
  year amortization
• Cumulative balances should be as follows
• Deferred tax liability 20,000
• Non-current tax payable (reserve) 40,000
• Since the taxpayer deducted 150,000 and should
  have only amortized 50,000 the payment owed to
  the IRS is 40,000 (100,000 x 40)

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Uncertain Tax Positions FIN 48Example
Taxable Temporary Difference

• The entry to record the settlement would be as
  follows
• Noncurrent income tax payable 40,000 Cash
  (payment to IRS) 40,000
• In future years, there should be a current
  amortization deduction taken in the provision and
  the return, so the entry each year in the future
  will be as follows
• Current income tax receivable 4,000Deferred
  tax expense 4,000 Current tax benefit
  4,000 Deferred tax liability 4,000

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Uncertain Tax Positions FIN 48Examples
Temporary Difference

• The preceding example did not take into account
• Interest and penalties
• Any financial statement impairment or write-down
  of the intangible
• The fact that a deferred tax liability related to
  an indefinite lived asset cannot be offset
  against any deferred tax assets for purposes of
  determining valuation allowance

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Uncertain Tax Positions Fin 48Temporary
Differences

• Another way to look at this is to maintain two
  parallel sets of deferred tax roll-forwards
• Roll-forward 1 will track the differences
  between the book basis and the as filed tax
  basis in other words, what FAS 109 already
  requires, pre-FIN 48
• Roll-forward 2 will track the differences
  between the book basis and the more likely than
  not tax basis that may be recorded under FIN 48
• The difference between deferred taxes computed
  under Rollforward 1 and Rollforward 2 will be
  the reserve in current or non-current income
  taxes payable

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Uncertain Tax Positions Fin 48Temporary
Differences

• The Parallel Rollforward method has several
  advantages
• Easier to track differences and maintain
  integrity of deferred tax computations
• Enables provision to return reconciliation more
  easily
• Better SOX 404 controls
• Entries recorded on a gross basis making it
  easier to reconcile tax accounts

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Uncertain Tax Positions Fin 48Temporary
Differences

• For example, the initial entry in the taxable
  temporary difference example under the parallel
  rollforward approach would be as follows
• Current tax receivable 60,000Deferred tax
  expense 60,000 Deferred tax
  liability 60,000 Current tax expense
  (benefit) 60,000To record as-filed tax
  benefit of acquired intangible
• Deferred tax liability 56,000Current tax
  expense (benefit) 56,000 Non-current tax
  payable (reserve) 56,000 Deferred tax
  expense 56,000To record reserve for uncertain
  tax position

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FIN 48 Financial Statement Disclosures
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Uncertain Tax Positions FIN 48Required
Disclosures

• The accounting policy regarding classification of
  interest and penalties
• Tabular reconciliation of unrecognized tax
  benefits, including
• Beginning balance
• Gross additions/reductions to UTP liability from
  prior period tax positions
• Gross additions/reductions to UTP liability from
  current period tax positions
• Decreases resulting from settlements with tax
  authorities
• Decreases resulting from the lapse of the statute
  of limitations
• Changes in interest and penalties, if classified
  as income taxes
• Ending balance

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Uncertain Tax Positions FIN 48Required
Disclosures

• The total of uncertain tax positions that, if
  recognized, would impact the effective tax rate
• For items where it is reasonably possible the
  estimate of the realized tax benefit will
  materially change in the next 12 months
• Nature of the uncertainty
• Nature of the event that could cause the change
• Estimated range of reasonably possible change

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Uncertain Tax Positions FIN 48Required
Disclosures

• The amount of interest and penalties recorded in
  the income statement and balance sheet
• A list of open tax years by major jurisdiction
• In the fiscal year of adoption, the cumulative
  effect of the change recorded as an adjustment to
  retained earnings

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Uncertain Tax Positions FIN 48Sample
Disclosures

• See FIN 48, A33 for narrative disclosure
  discussing tax jurisdictions filed in, open years
  under the statute of limitations, IRS audit
  status including the range of anticipated
  payments and interest and penalties accrued
• The example lists transfer pricing and state
  nexus as the tax positions with the greatest
  uncertainty and that adverse settlements would
  significantly impact the effective tax rate
• The example also shows a sample reconciliation of
  the liability (reserve) for uncertain tax
  positions

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Questions?

• Call to speak with one of the local
• RSM Tax Professionals at
• 619.280.3022
• E-mail me Erica.Costanzo_at_rsmi.com