Accounting for Uncertainty in Income Tax Positions: FASB Interpretation No. 48

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1 Accounting for Uncertainty in Income Tax Positions: FASB Interpretation No. 48 by Randall D. McClanahan and Elizabeth F. Sublette Introduction On July 15, 2006, the Financial Accounting Standards Board ( FASB ) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Tax Positions ( FIN 48 ). 1 FIN 48 is intended to clarify the guidance issued in FASB Statement No. 109, Accounting for Income Taxes ( FAS 109 ) 2 and introduces new rules that significantly change how companies account for uncertain income tax positions. The goal of FIN 48 is to reduce inconsistencies in approaches to recognizing, measuring and presenting income taxes in financial statements. To accomplish this, FIN 48 establishes consistent criteria that an individual tax position must satisfy in order for any of the benefit of that position to be recognized in the entity s financial statements. FIN 48 is effective for all tax years beginning after December 15, As a result, FIN 48 is currently being implemented. The implementation, however, could be quite expensive and could potentially lead to conflicts between auditors and internal and/or external tax advisors. Scope FIN 48 applies to all entities that prepare GAAP financial statements. In addition to business enterprises, this includes not-for-profit organizations, pass-through entities, 1 FASB Interpretation No. 48, Accounting for Uncertainty in Income Tax Positions. 2 FASB Statement No. 109, Accounting for Income Taxes.

2 (such as S corporations, limited liability companies and limited partnerships ) and real estate investment trusts (REITs). 3 for in accordance with FAS FIN 48 applies to all tax positions that are accounted The term tax position is defined to include a position in a previously filed tax return or a position expected to be taken in a future return. 5 The term also includes (i) a decision not to file a return; (ii) an allocation or shift of income between jurisdictions; (iii) a characterization of income; (iv) a decision to exclude taxable income; and (v) a decision to classify an entity as tax-exempt. 6 Application of FIN 48 FIN 48 outlines a two-step approach for evaluating uncertain tax positions. The first step, recognition, occurs when the entity concludes that a tax position, based solely on its technical merits, is more likely than not to be sustained upon examination. 7 If step one has been satisfied, the entity must then measure the amount of the tax benefit to be recognized. The measurement amount is equal to the largest amount, determined based on cumulative probability, that is more likely than not to be realized upon ultimate settlement. 8 To be able to apply FIN 48, an entity will need to identify all existing tax positions as of the date they adopt FIN 48. The entity must first determine the unit of account for identifying what constitutes an individual tax position. FIN 48 states that the unit of account is based on the level at which an entity prepares and supports the amounts claimed in the tax return and the approach the entity anticipates the taxing authority will 3 FIN 48 at Par FIN 48 at Par FIN 48 at Par Id. 7 FIN 48 at Par FIN 48 at Par. 8. 2

3 take in an examination. 9 The entity should use its judgment in determining what constitutes an appropriate unit of account. 10 The selection of a unit of account for a particular position is very important, because this unit should be consistently applied unless subsequent facts and circumstances dictate otherwise. 11 Recognition The first step in the FIN 48 analysis is to evaluate the tax position for recognition. An entity must initially recognize the financial statement effects of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. 12 fifty percent (50%). 13 The term more likely than not means a likelihood of more than In analyzing whether a tax position meets the more likely than not threshold, the entity must assume that the tax position will be discovered by the taxing authorities and that those authorities will have access to all relevant facts and information. 14 Also, if past administrative practices and precedents of the taxing authority are widely understood, this should be factored into the entity s assessment of the more likely than not standard. 15 After considering these factors, the entity should base its determination on the weight of the relevant tax law authorities in existence at the reporting date. Each position should be evaluated individually; aggregation of tax positions is not allowed. 16 As a result, the entity s determination of a unit of account is very important since units of account may not be aggregated. 9 FIN 48 at Par Id. 11 FIN 48 at Par FIN 48 at Par FIN 48 at Par FIN 48 at Par Id. 16 Id. 3

4 Measurement The second step in the FIN 48 analysis is measurement. If a tax position meets the recognition threshold in step one, the entity must then measure the amount of the benefit that should be recognized for that tax position. The amount of the benefit is the largest amount that is more likely than not to be realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. 17 FIN 48 uses the concept of cumulative probability to determine the correct amount of tax benefit to be recognized. For example, assume an entity estimates the amounts and probabilities of possible outcomes of a tax position as follows: Possible Benefit Outcome Percentage Probability of Successful Outcome Cumulative Percentage Probability of Success $100 15% 15% $80 25% 40% $60 30% 70% $40 20% 90% $0 10% 100% In this example, $60 is the largest benefit that has a greater than fifty percent (50%) chance of being realized upon ultimate settlement. Therefore, the entity would recognize a $60 tax benefit in its financial statements. A table similar to the one above may be necessary where there are a number of possible outcomes with different probabilities of occurring. In other cases, there may be a single amount that is perceived to be more than fifty percent (50%) likely. These 17 FIN 48 at Par. 8. 4

5 positions are generally routine transactions for which the tax law is clear and unambiguous. If the tax position is highly certain, the cumulative probability analysis is unnecessary. FIN 48 could create potential conflicts between external auditors and an entity s internal and/or external tax advisors. Prior to FIN 48, the position taken on a tax return was commonly accepted by financial accountants for financial accounting purposes. To effectively comply with FIN 48, an entity will have to document the basis for decisions on recognition and measurement of a tax position. Such documentation will result in candid discussions regarding the strengths and weaknesses of positions taken on an entity s tax return and possibly, as a result, accruals of liabilities for taxes, interest and, potentially, penalties, as discussed below. This is not a commentary on the integrity of tax advisors but FIN 48 has potentially changed the outcome resulting from such candid and full documentation of tax positions by tax advisors. Since auditors have to understand the entity s basis for recognition and measurement, auditors have a duty to probe tax advisors for a complete understanding of the applicable tax positions in order to comply with FIN 48. Additionally, it is certainly possible that the recognition of additional tax expense, interest and penalties and the disclosures required by FIN 48 will lead to greater scrutiny of the entity by the IRS. Interest and Penalties If interest would be required to be paid on an underpayment of taxes, interest must be accrued at the statutory rate on the difference between the amount of the tax position recognized under FIN 48 and the amount recognized on the tax return. 18 Additionally, if penalties would be imposed under the tax law, an entity must recognize 18 FIN 48 at Par

6 an expense equal to the statutory penalty in the period in which the entity takes the applicable position. 19 Thus, FIN 48 would require an entity to accrue interest and possibly penalties if a position taken on the tax return is not equal to the amount recognized under FIN 48! This requirement leads some tax advisors to argue that FIN 48 will require an entity to disclose too much information regarding its tax positions. Subsequent Recognition, Derecognition and Measurement Under FIN 48, an entity cannot subsequently change its evaluation of information that was available in a previous reporting period. However, if new information becomes available, the entity can then change its original evaluation of a tax position. In other words, the only changes in judgment that should result in changes in recognition, measurement, or both of a tax position are those resulting from the evaluation of new information. 20 If the entity evaluates new information and determines that a tax position should now be recognized, that recognition would occur in the first interim reporting period in which the tax position meets the recognition threshold. 21 Recognized tax benefits should be derecognized in the period in which the likelihood of the position falls below the recognition threshold (i.e., when the position no longer meets the more likely than not test). 22 New information can also result in changes in the measurement of positions in which a different amount of tax benefit should be recognized. 19 FIN 48 at Par FIN 48 at Par FIN 48 at Par FIN 48 at Par

7 Classification If the amount reported on the entity s tax return for a certain tax position exceeds the amount measured under FIN 48, that difference is considered a liability for unrecognized tax benefits (or the amount of a net operating loss carryforward or refund, as applicable, is reduced). 23 The liability should be classified as current if anticipated to be paid within one year or within the operating cycle, if longer. 24 Unless the liability results from a taxable temporary difference created by a tax position that meets the recognition threshold, it should not be classified as a deferred tax liability. 25 Disclosures FIN 48 also requires certain disclosures in the entity s financial statements, including the following: 26 1) a tabular reconciliation of the beginning and ending balances of unrecognized tax benefits; 2) information concerning tax positions for which a material change in the unrecognized tax benefit liability is reasonably possible in the next twelve (12) months; 3) the total amount of unrecognized tax benefits, that, if recognized, would impact the effective tax rate; 4) the total amount of interest and penalties recognized in the income statement and in the balance sheet; and 5) a description of open tax years by major jurisdiction. 23 FIN 48 at Par Id. 25 FIN 48 at Par FIN 48 at Par

8 Entities and tax professionals have expressed concern that the tabular reconciliation could provide a roadmap for taxing authorities. However, FASB believes that such disclosures provide useful information to financial statement users about estimates that require judgment on the part of management. Effective Date As mentioned previously, FIN 48 is effective for fiscal years beginning after December 15, Therefore, an entity with a calendar year must adopt and begin to apply FIN 48 as of January 1, Only tax positions that meet the recognition threshold at the effective date may be recognized upon the adoption of FIN The entity should report the cumulative effect of applying FIN 48 by adjusting the opening balance of retained earnings and disclose this effect in the financial statements. 29 Practical Considerations On October 17, 2006, the IRS announced an initiative to help taxpayers resolve uncertain tax positions prior to the adoption of FIN 48. Participants in the program were required to agree to complete transparency and to make all information and documentation available to the IRS. Therefore, most business enterprises were not eager to participate in this initiative. Most recently, FASB rejected requests from tax professionals and businesses to delay the implementation of FIN 48 for one year. On January 17, 2007, FASB confirmed the implantation date for FIN 48 as December 15, Calendar year companies must now scramble to determine the effect of FIN 48 on their financial statements before the end of the first quarter of Affected entities should develop a strategy for keeping 27 FIN 48 at Par FIN 48 at Par FIN 48 at Par. 23 and 24. 8

9 track of uncertain tax positions as well as review their current tax policies and disclosures to ensure they are in compliance with FIN 48. Conclusion FIN 48 modifies the rules for recognition, measurement and disclosure of the accounting for uncertain income tax positions. To comply with FIN 48, an entity must identify all its open tax positions and apply the recognition and measurement principles to those positions. The implantation of FIN 48 could be costly, as many businesses may have to engage the services of a tax professionals to review and summarize the prior open tax positions. Depending on the entity s current practices, the adoption of FIN 48 may have a significant impact on its financial statements by clarifying the standard that tax benefits must meet before they can be recognized. Additionally, FIN 48 will require more independent communication between tax advisors and financial accountants and may generate a conflict between these professionals, as the accurate disclosure of tax positions could increase the chance that the entity will ultimately be audited. Randall D. McClanahan is a partner with Johnston Barton Proctor & Rose LLP in Birmingham, Alabama and serves as chairman of the Accounting Standards Subcommittee of the ABA Section of Business Law s Law and Accounting Committee. Elizabeth F. Sublette is an associate with Johnston Barton Proctor & Rose LLP. 9