ALERT: Tax. New Financial Reporting Rules Will Require Disclosure of Uncertain Tax Positions

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1 ALERT: Tax May 2007 New Financial Reporting Rules Will Require Disclosure of Uncertain Tax Positions FIN 48, which requires companies to disclose uncertain tax positions on their financial statements, became effective for all tax years beginning after December 15, In early April, FASB approved FSP FIN 48-a, providing guidance for determining whether a tax position has been settled for FIN 48 purposes. Although the filing deadline for the first quarter of FIN 48 reporting requirements has passed, many companies are still uncertain about their uncertain tax positions. FIN 48, which requires companies to disclose uncertain tax positions on their financial statements, became effective for all tax years beginning after December 15, In January, the Financial Accounting Standards Board (FASB) declined to delay the implementation of the new rule. However, in early April, FASB did approve FSP FIN 48-a, providing guidance for determining whether a tax position has been settled for FIN 48 purposes. The new FIN 48 rules require a minimum more likely than not standard for tax opinions to support a tax position that either reduces a tax liability or generates a tax refund. Although the more likely than not standard assumes a 51 percent chance of surviving a challenge by a taxing authority, many accounting firms, including the Big Four, may require an even higher level of opinion before permitting an audit client to take a tax position without creating at least a partial accrual and disclosing the position. The rule requires a company to assume that a tax position which creates an economic benefit will be examined by a taxing authority, eliminating the company s ability to consider the probability of audit when determining whether to disclose an uncertain tax position. For reasons discussed below, multi-state companies that have implemented state tax planning structures, taken no-nexus positions, or simply do business in many states have indicated difficulty dealing with this new reporting rule in their financial statements. 1 This Alert discusses the history of the reporting requirements and makes recommendations on how companies can deal with reporting potential uncertain tax positions for which they have not reserved. Historical Context In the past, all uncertain income tax positions (UTPs) were accounted for under Statement of Financial Accounting Standards No. 5, Accounting for Contingencies (FAS 5), while the effect of income taxes was governed by Statement of Financial Accounting Standard No. 109, Accounting for Income Taxes (FAS 109). FAS 109 guides taxpayers on the recognition of current taxes payable/refundable and deferred or future tax benefits/liabilities associated with transactions that have already been recognized in financial statements or on tax returns. Essentially, FAS 109 considered the taxpayer s existing tax posture and projected its effect on GREENBERG TRAURIG, LLP ATTORNEYS AT LAW

2 the company s future financial position, but did not contemplate the current or future effect of a UTP. Alternatively, FAS 5 required companies to set up a reserve, or accrual, for any UTP where the liability was probable and the amount of loss could be reasonably estimated. In other words, if the taxing authority was likely to impose a tax, then the accrual should be established. If the loss was not probable or could not be reasonably estimated, then FAS 5 did not require financial statement disclosure of the contingent liability. The FAS 5 analysis is more lenient than the FAS 109 standards. The Trend of Inconsistency Nevertheless, many auditors began requiring a higher level of review (i.e., more likely than not or should opinions) for transactions involving tax planning. Although this increased level of scrutiny may have provided for more accurate disclosures on an individual basis, the diversity in review meant that financial statements were no longer providing a consistent comparison of companies financial positions. For example, if Company A s auditor required it to establish that a taxing authority was more likely than not to determine that selling widgets in the state would not subject it to franchise tax therein, but Company B s auditor only required it to demonstrate that the same taxing authority was likely not to impose franchise tax based upon selling widgets, then Company A would need to disclose the potential liability, while Company B would not. Thus, the different levels of review imposed by the auditors would make Company B appear to have a stronger financial position than Company A, even though they have the exact same contingent tax liability. New Rules FIN 48 This disparity between reporting standards led the Financial Accounting Standards Board to develop FIN 48, an interpretation of FAS 109. FIN 48 applies to all tax positions that are within the purview of FAS 109, including positions that were previously taken (i.e., already appear on a tax return). In addition, FIN 48 applies to almost all entities, irrespective of whether taxes are generally imposed at the entity level. For example, the guidance applies to pass-through entities (i.e., partnerships, limited liability companies, etc.), not-for-profit organizations, and entities qualifying for a deduction for dividends paid (i.e., real estate investment trusts and regulated investment companies). FIN 48 requires a two-step process for the reporting of UTPs. First, a taxpayer must determine whether it can recognize the benefit of the uncertain position. Second, it must measure the amount of benefit to be recognized. Although the technical measurement is the largest amount of the benefit that is more likely than not to be realized after challenge by a taxing authority, auditors appear to Page 2

3 be requiring companies to obtain at least should level opinions before allowing them to assert a UTP without creating any reserve. Under the technical requirements, the recognition process requires a more likely than not standard to support the reporting of a position that either reduces a tax liability or generates a tax refund. In other words, the company must determine whether it has a 51 percent chance of maintaining the financial benefit of the uncertain position when it is challenged by a taxing authority. For example, if Company A is deriving a state income tax benefit in Florida for royalties paid to its Delaware intangible holding company, does it have a 51 percent chance of maintaining that deduction under audit, considering the numerous state court decisions concluding that royalty companies are subject to state income tax? If the answer is that there is not a 51 percent chance of success in the event of such a challenge, then the position must be disclosed on the financial reports and an accrual must be established. However, even if the position has a 51 percent chance of success, then the position may still need to be disclosed and a partial accrual established if it does not rise to the level of a highly certain tax position. In order take the entire benefit of a tax position in the financial statements, the position must rise to the level of a highly certain tax position. A highly certain tax position is one supported by clear, unambiguous tax laws. Many large auditor firms indicate that taxpayers are unlikely to have a highly certain tax position and those taking that position need should level supporting opinions. A should level opinion generally opines that a tax position is at least 70 percent likely to withstand attack by the taxing authority. If a should level of opinion is unattainable, then the company will be required to create a reserve for the portion of the benefit that falls short of the should level. Unfortunately, even the smallest reserve requires disclosure and tracking (discussed below). Once an accrual is established, it may only be reversed when the more likely than not threshold is met by the reporting date, the pertinent statute of limitations has expired, or the UTP is effectively 2 settled through negotiation or litigation. Due to confusion about when an accrual could be reversed, FASB approved FSP FIN 48-a, which explains that a UTP does not need to be certain, or even legally extinguished, in order to be effectively settled. Rather, the accrual may be reversed if the taxing authority has completed its examination procedures, the company does not intend to appeal or litigate the UTP after the audit, and, based on the taxing authority s widely understood policies, the company considers it highly unlikely that the taxing authority would examine/reexamine the UTP included in the completed audit. 3 When making any recognition determination under FIN 48 or FSP FIN 48-a, a company must assume that a tax position which creates an economic benefit will be examined by the taxing authority and that such authority will have full knowledge of all relevant facts. Thus, the probability of a position being audited cannot be considered as a factor when determining whether a UTP should be recognized. Page 3

4 FIN 48 also requires detailed tracking of UTPs. The tracking is required to be in a tabular form, including detail for any UTP which creates a benefit that has the reasonable possibility of significantly increasing/decreasing in a 12-month period. In addition, this table must be updated annually, or in the reporting period in which an event takes place requiring recognition or derecognition of a benefit. Many companies feel that this level of detail provides a road-map for the taxing authorities and would prefer not to disclose such information. Although the IRS has made statements that it will analyze financial reports (and possibly demand the underlying workpapers) to hunt for potential audit candidates, state taxing authorities have not made any such pledge. The Practical Fallout of FIN 48 As a result, many companies will be scrambling to obtain should opinions from their tax advisors so that these UTPs will not need to be disclosed on their financial statements. Although FIN 48 does not require an independent tax opinion, auditors need to be cautious when providing tax opinions to audit clients. Under current professional standards, not only are audit firms likely to decline writing tax opinions for audit clients, but companies are likely to look to third parties for tax opinions in order to ensure their auditor s independence. With only four major audit firms left in arena, companies will be turning to law firms to provide these much needed opinions. Although FIN 48 applies to all income taxes, Federal income taxes always fell under FAS 109 and the more likely than not standard already applied. Taxpayers may need to make some adjustments based on the clarification of the measurement rules, but, generally, the likelihood is that they already have reserves in place for Federal tax positions. State taxes, alternatively, were often considered to fall under the less stringent FAS 5 rules and potential state tax liabilities were not disclosed. Now that state income taxes clearly come within the purview of the stricter FIN 48, companies will be required to establish accruals, provide disclosures, and document their state tax exposure with as much, if not more, detail than they did for Federal taxes. Companies will no longer have the ability to classify their nexus posture as a UTP subject to the relaxed requirements of FAS 5. Therefore, tax planning that involved a multi-state company and required the company to get an opinion for Federal purposes, even if old and cold, may require that company to get an opinion for state tax purposes to avoid putting up a state tax accrual. For example, planning that required an opinion stating that the IRS was more likely than not to respect the form of a transaction rather than applying the step transaction doctrine may need an opinion on the state level, even though the auditors accepted that the transaction did not need a state tax accrual at the time of the transaction. The opinion may even need to be stronger than the original more likely than not document. Page 4

5 Companies that have taken aggressive tax positions and cannot get the required tax opinion might want to consider entering into a voluntary disclosure agreement with the applicable tax authority to avoid the need to report the UTP. Many state taxing authorities are willing to negotiate a voluntary disclosure agreement that would limit the number of years to which they will look back. This could be very important to a company that adopted a tax structure that took the position that there was no filing requirement. In such a case, the tax authority would likely maintain that there is no statute of limitations (because no return was filed), allowing an indefinite look back period. A voluntary disclosure agreement could limit the number of years a taxing authority will examine. The Greenberg Traurig Tax Department is ready to assist clients with all of the new challenges presented by FIN 48. Pursuant to U.S. Treasury Department Circular 230, any tax advice contained in this communication was not intended or written to be used, and cannot be relied on or used for the purpose of i) avoiding any tax penalties or ii) to promote, market or recommend to another party any matter(s) addressed herein. 1 See Corporate Executives Discuss With RIA FIN 48 Requirements, Problems Encountered, and Additional Resources and Guidance Needed (04/30/2007), State & Local Taxes Weekly Newsletter (RIA). 2 On March 27, 2007, FASB approved an amendment to FIN 48, FSP FIN 48-a, substituting effectively for ultimately settled. 3 A separate GT Alert regarding the details of FSP FIN 48-a will be issued at a future date. Page 5

6 This GT Alert was written by Taryn D. Goldstein* and Marvin A. Kirsner in the Boca Raton office. Questions about the subject matter of this Alert should be addressed to: Taryn D. Goldstein ( ; Marvin A. Kirsner ( ; Albany Amsterdam Atlanta Boca Raton Boston Chicago Dallas Delaware Denver Fort Lauderdale Houston Las Vegas Los Angeles Miami New Jersey New York Orange County Orlando Philadelphia Phoenix Sacramento Silicon Valley Tallahassee Tampa Tokyo Tysons Corner Washington, D.C West Palm Beach Zurich *Law Clerk/J.D.; admitted in New York and New Jersey only. This Greenberg Traurig ALERT is issued for informational purposes only and is not intended to be construed or used as general legal advice.the hiring of a lawyer is an important decision. Before you decide, ask for written information about the lawyer s legal qualifications and experience. Greenberg Traurig is a trade name of Greenberg Traurig, LLP and Greenberg Traurig, P.A Greenberg Traurig, LLP. All rights reserved. Page 6