Legal and Practical Issues in
Applying FIN 48
By David Colker
The Financial Accounting Standards Board (FASB) recently issued Interpretation No. 48 (FIN 48), which addresses accounting for uncertainty in income taxes. FIN 48 is an interpretation of FASB Statement No. 109 (FAS 109), which generally addresses accounting for income taxes. FIN 48 also amends FASB Statement No. 5, Accounting for Contingencies, to eliminate its applicability to income taxes. FIN 48 is effective for fiscal years beginning after December 15, 2006.
Lack of Specificity in FAS 109 Led to Inconsistent Criteria
The validity of an income tax position taken on a tax return is a matter of law. It is not controversial to recognize the benefit of the tax position taken by an enterprise in its financial statement when the confidence is high that the tax position will be sustained upon examination by the tax authority.
However, in some cases, the law may be subject to various interpretations; whether a tax position will ultimately be sustained may be uncertain. FAS 109 contains no specific guidance on how to address uncertainty in accounting for income tax assets and liabilities. As a result, diverse accounting practices have developed resulting in inconsistency in the criteria used to recognize, derecognize, and measure benefits related to income taxes. The application of FIN 48 will result in increased comparability of financial statements because all income tax positions will be evaluated using consistent criteria.
The Basic Elements of FIN 48
Under FIN 48, all income tax positions (including foreign income tax positions) are evaluated in a two-step process.
The first step is recognition. The enterprise determines whether it is "more likely than not" that a tax position will be sustained upon examination, including resolution of any related appeals or litigation, based on the technical merits of the position. In considering the merits of a tax position, the enterprise must assume that the position will be examined by the tax authority with full knowledge of all relevant information.
The second step is measurement. A tax position that meets the "more likely than not" recognition threshold is then measured to determine the amount of benefit to recognize in the financial statement. The tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement.
Differences between a tax position taken on a return and the amounts recognized in the financial statements will generally result in (i) an increase in a liability for income taxes payable or a reduction in income tax refund receivable; or (ii) a reduction in a deferred tax asset or an increase in a deferred tax liability.
Tax positions that previously failed to meet the "more likely than not" threshold should be recognized in the first subsequent financial reporting period in which the threshold is met. Previously recognized tax positions that no longer meet the "more likely than not" threshold should be derecognized in the first subsequent financial reporting period in which the threshold is no longer met.
FIN 48 only applies to income taxes. Thus, uncertainties concerning, for example, sales tax, VAT, and property taxes, are not subject to these rules.
Issues Concerning the Recognition Step
Defining the Tax Position. In the recognition step, it is necessary to evaluate the technical merits of each tax position (other than immaterial items). A tax position is a position taken in a previously filed return or one expected to be taken in a future tax return that is reflected in measuring current or deferred income tax assets or liabilities. A tax position also includes a decision not to file a tax return.
In applying FIN 48, it is necessary to determine the appropriate "unit of account" for a tax position. In making this determination the enterprise should consider the manner in which it prepares and supports its tax return; it should also anticipate the approach the tax authority will take during an examination.
For example, a company may claim a $1 million research and experimentation credit on a tax return. It is possible that the entire credit claim is the unit of account, and thus a tax position that requires evaluation. Alternatively, it is possible that various aspects of the credit may be separately evaluated. For example, if the credit claim relates to two separate projects, then it is possible that each project will be evaluated separately to determine if the associated expenditures qualify. If the taxpayer believes that the tax authority will evaluate the credit in that manner, then the "more likely than not" test should be applied to each project. But if only one project meets the test, then all expenditures associated with the other project would not result in any tax benefit. It is also possible that the government might look separately at other issues, such as whether senior personnel whose wages were treated as qualifying expenditures participated in the research activity or directly supervised it.
In the abstract, it is not clear how finely companies will have to disaggregate tax positions to reflect possible discrete challenges by the IRS. Presumably, if the enterprise uses reasonable judgment in anticipating the approach the tax authority will take during an examination, it is in compliance with FIN 48. One valuable source of information in this regard may be the approach taken by the tax authority in prior audits of the enterprise or, if known, of similar enterprises.
Applying the "more likely than not" test. As a general matter, in applying the "more likely than not" test to a tax position:
(i) it shall be presumed that the tax authority will examine the tax position and will have full knowledge of all relevant facts;
(ii) the technical merits of a tax position should derive from sources of authority in the tax law and their applicability to the facts and circumstances; and
(iii) each tax position must be evaluated without considering the possibility of offset.
That is, legal opinions used by an enterprise for purposes of compliance with FIN 48 will need to be consistent with these requirements.
If an enterprise does identify an offset in connection with an audit, then presumably that tax position would need to be evaluated as a distinct claim for refund that would be asserted in the current accounting period, since it cannot be offset against any other tax position.
The preparation of a legal opinion or memorandum that documents compliance with the recognition or measurement step of FIN 48 raises questions about the availability of the attorney-client privilege. If the attorney’s opinion is provided to the auditor of the enterprise, then the privilege will be waived. Moreover, the privilege does not apply if the opinion was prepared in connection with the preparation of the tax return. Also, tax accrual workpapers (defined in Chief Counsel Notice 2004-10) are not privileged. These include all workpapers relating to reserves for current, deferred, and potential tax liabilities. It is possible that legal opinions and memoranda prepared for a taxpayer to help document its tax reserve determinations under FIN 48 may be treated as tax accrual workpapers.
It is the current IRS policy (as set forth in Announcement 2002-63) to only seek tax accrual workpapers for listed transactions, unless the listed transaction is not disclosed, in which case all tax accrual workpapers may be sought. The IRS policy is incorporated in Internal Revenue Manual Section 4.10.20. It may be beneficial for any legal opinion that is prepared solely for the purpose of applying FIN 48 to be clearly so labeled in order to document that the memorandum may be a tax accrual workpaper. In this event, it may be possible to rely on existing IRS policy and not disclose the document in the course of an audit. Clients should adopt the general approach of considering, at the outset of each engagement, the purpose for which a legal opinion or memorandum is being prepared and whether it may be protected by the attorney client privilege or possibly subject to the IRS policy concerning tax accrual workpapers.
Change in judgment. Once an enterprise determines that a tax position should be recognized or not recognized, it is possible for that determination to be altered in a later year. However, a subsequent change in judgment should result from the evaluation of new information, and not from a new evaluation of information that was available in a previous financial period.
Examples. Appendix A to FIN 48 provides illustrative guidance to FIN 48.
One example addresses the so-called administrative practice of allowing the establishment of a capitalization threshold. If the taxpayer is concerned that this position may lack technical merit, it may still recognize the position if, based on previous experience or the experience of others, it believes it is "more likely than not" that its practice will be allowed.
A second example addresses nexus. If a taxpayer has not filed tax returns in a jurisdiction where it has nexus, then generally the statute of limitations will never close. If it is an administrative practice to only look back a limited number of years when enforcing nexus rules, then a taxpayer may, based on that practice, be able to reach a "more likely than not" opinion concerning whether there are tax liabilities associated with prior periods that precede the look-back period (where the statute of limitations is still technically open).
Issues Concerning the Measurement Step
A tax position that meets the "more likely than not" recognition threshold is initially measured as the largest amount of tax benefit that is greater than 50 percent likely to be realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. FIN 48 states that the measurement of the tax position should consider the amounts and probabilities of the outcomes that could be realized upon ultimate settlement using the facts, circumstances, and information available at the reporting date. This definition raises a broad range of issues.
Experience indicates that the amount of a settlement that can be achieved with respect to any tax position will change over time as the issue is addressed in the tax controversy process. Thus, in order to apply FIN 48, a taxpayer may need to consider the process it will employ to try to settle a tax issue. It is also possible that a taxpayer may change strategy in the course of contesting a tax issue, which in turn may lead to a change in ultimate settlement prospects.
Determining the "ultimate settlement." The measurement test focuses on "ultimate settlement" with a tax authority. As a matter of practice, the "ultimate settlement" that can be achieved with a tax authority depends on many factors, including the procedural status of the matter. Also, the ultimate settlement may depend on how far a taxpayer is willing to go to contest a matter, and how risk averse a taxpayer is.
At the audit level, most tax authorities do not settle individual tax issues through compromise, although it may be possible to offset one issue against another at the audit level. Thus, if a taxpayer intends to settle an audit at the audit level, and plans to try to offset one issue against another, and if there is a greater than 50 percent chance of accomplishing the offset, then presumably the issue to be given up is measured at zero benefit. One type of tax position that might be susceptible to compromise at the audit level is a tax position that involves valuation, such as a transfer pricing issue. If a taxpayer intends to settle such an issue at the audit level, then presumably the taxpayer must determine the greatest amount of tax benefit the IRS will allow that is at least 50 percent likely to be achieved.
Many taxpayers settle disputed US federal income tax positions with IRS appeals. Assuming a taxpayer intends to settle a disputed tax matter with IRS appeals, then it is necessary to determine the highest benefit that IRS appeals will allow that is at least 50 percent likely to be realized.
Settlements can also be achieved during a tax litigation process and, in fact, most judicial bodies strongly encourage settlement. If a taxpayer is engaged in tax litigation, but is still willing to settle the matter, then presumably it must determine the highest settlement amount that might be offered that is at least 50 percent likely to be realized and use that amount to measure the tax position.
Significance of intent not to settle. What if a taxpayer does not want to settle a contested tax position and believes it is necessary to seek a judicial determination of the matter? In that case, it is not clear how FIN 48 would apply.
If a taxpayer does not intend to settle and the tax position satisfies the "more likely than not" recognition test, then must the taxpayer still measure the tax position based on the highest settlement amount that might be offered that is at least 50 percent likely to be realized? The "settlement" test would be hard to apply in this case, because there is no context in which the taxpayer is attempting to achieve such a settlement.
Arguably, FIN 48’s reference to "ultimate" settlement should include a final court determination in those cases where a taxpayer intends to seek such a determination. In such an event, presumably the entire benefit would be recognized if it is "more likely than not" the correct tax position. This issue deserves clarification.
Illustrative examples in FIN 48. Examples provided in FIN 48 illustrate these measurement rules.
A first example addresses highly certain tax positions. That example involves wage expense not subject to limitations on deductibility, not subject to capitalization, and timely paid within the statutorily required time frame. The example confirms that "[b]ecause of the difficulty of defining an uncertain tax position, the Board decided that all tax positions are subject to the provisions of [FIN 48]". However, in this example, because management has a high confidence level in the technical merits of the position, it clearly meets the "more likely than not" standard, and because management is highly confident that it is greater than 50 percent likely that the full amount of the tax position will be allowed, the full amount of the tax benefit is recognized in the financial statements.
A second example involves a taxpayer that has "confidence in the technical merits of a tax position,…but management also believes it is likely it would settle for less than the full amount of the entire position when examined." In this case, the benefit is measured as the highest amount that is 50 percent likely to be realized in settlement.
In two other examples, management believes that it is less than 50 percent likely that it could sustain its tax position permitting expensing/rapid depreciation of an item upon ultimate settlement, but management is also certain it could amortize/deduct the item over a longer period. The examples state that the tax position (of being able to deduct the item over some period) qualifies for recognition, but that management may not claim the benefits associated with the tax return position because there is a less than 50 percent chance of realizing that outcome through settlement.
Interest and Penalties
When the tax law requires interest to be paid on an underpayment of income taxes, an enterprise must begin recognizing interest expense in the first period when the interest would accrue. Interest accrues on the difference between the amount taken on the return and the amount recognized under FIN 48. The taxpayer need not accrue penalties as long as it is "more likely than not" that penalties will not apply. Otherwise, penalties also must be accrued. Interest may be classified in the financial statements as either income taxes or interest expense. Penalties may be either taxes or another expense category. Such classification elections, however, must be consistently applied.
Year-End Disclosure
An enterprise must disclose a variety of information at the end of each annual reporting period. The information includes:
(i) a tabular reconciliation of the total amounts of unrecognized tax benefits at the beginning and end of the period;
(ii) the total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate;
(iii) certain information about interest and penalties;
(iv) for tax positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly increase or decrease within 12 months, (A) the nature of the uncertainty, (B) the nature of the event that could occur to cause the change, and (C) an estimate of the range of reasonably possible change or a statement that such an estimate cannot be made; and
(v) a description of tax years that remain subject to examination in major tax jurisdictions.
Implementation
FIN 48 must be applied to all tax positions upon initial adoption. Only tax positions that meet the "more likely than not" recognition threshold may be recognized or continue to be recognized. The cumulative effect of applying FIN 48 must be reported as an adjustment to the opening balance of retained earnings. Accordingly, calendar-year taxpayers will need to make this adjustment as of January 1, 2007. The cumulative effect of the change must also be disclosed.
Generally, under FAS 109, taxpayers have not claimed financial statement benefit for tax positions that did not satisfy the "probable" threshold. If taxpayers have been using this standard, it is possible that some tax positions that did not meet the "probable" standard will meet the "more likely than not" standard. These tax positions will need to be recognized to the extent of the largest tax benefit that is greater than 50 percent likely to be realized upon ultimate settlement. With respect to tax positions that have been recognized and will continue to be recognized under FIN 48, taxpayers must apply the new measurement test and compare the outcome of that test with existing levels of tax reserves.
To successfully implement FIN 48 and apply it consistently over time, companies will also need to develop an internal process that reliably identifies, analyzes, and assesses material income tax exposure on a global basis in conformity with FIN 48 methodology.
Summary
FIN 48 clarifies the accounting for uncertainty in income taxes.
For each material income tax position, an enterprise must determine whether it is "more likely than not" that the tax position will be sustained upon examination, including resolution of any related appeals or litigation, based on the technical merits of the position. For each tax position that meets the "more likely than not" recognition threshold, an enterprise must determine the amount of benefit to recognize in the financial statement. The tax position benefit is measured as the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. These determinations will require both technical legal analyses of tax positions as well as somewhat more subjective considerations of possible settlement outcomes.
Taxpayers will also need to apply FIN 48 to current income tax positions to calculate the adjustment, if any, to be made to the opening balance of retained earnings as of the first day of the first fiscal year to which it applies.
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