FIN 48 Considerations: Tax Attorneys Perspective Roger A. Pies and Adam Gropper As appeared in the April 30, 2007, edition of TAX NOTES, Volume 115, Number 5. Reprinted with permission.
FIN 48 Considerations: Tax Attorneys Perspective Roger A. Pies and Adam Gropper Baker Hostetler In June 2006 the Financial Accounting Standards Board issued Interpretation No. 48, dealing with the treatment of uncertain tax benefits. The new standards became effective for fiscal years beginning after December 31, 2006. There have been requests to delay the effectiveness of FIN 48, but it remains in effect at this time. In this article we raise a number of questions regarding how FIN 48 should be applied in some situations. We believe that, to a surprising extent, FIN 48 either fails to answer some fundamental questions or relies on flawed premises. We discuss the FIN 48 procedure for dealing with uncertain tax benefits, but only in a brief overview. We do not try to explain FIN 48 requirements in detail. It is assumed that the reader is familiar with FIN 48 s provisions. We also do not provide suggestions as to how FIN 48 should be interpreted, because the proper interpretation of FIN 48 is outside our area of expertise. Thus, the following discussion is from the perspective of a tax lawyer asked to provide guidance on uncertain tax benefits when that guidance will be used to meet FIN 48 requirements. We try to focus attention on issues that do not appear to have clear answers in FIN 48. 1 I. The FIN 48 Process in Brief The FIN 48 process begins with an identification of a company s uncertain tax position. The company must make a judgment regarding the appropriate unit of account. In an example involving research credits, FIN 48 describes the determination of the proper 1 Other commentators have also raised questions about the effect of FIN 48 in various situations. See, e.g., Neil D. Kimmelfield, FIN 48: Measuring Tax Benefits in the Real World, Tax Notes, Oct. 30, 2006, p. 501, Doc 2006-21304, 2006 TNT 210-26; W. Scott Rogers and Raymond G. Andrews, FIN 48 and Interest Accruals A Discussion With FASB, Tax Notes, Mar. 12, 2007, p. 1031, Doc 2007-4979, 2007 TNT 49-44; Brian R. Lynn, Blame It on Transparency, Tax Notes, Mar. 5, 2007, p. 945 Doc 2007-4514, 2007 TNT 44-40 Michael Urban and Tim Throndson, FIN 48: Potential Impact of Interest Computations and Penalties, Tax Notes, Feb. 19, 2007, p. 767, Doc 2007-2909, 2007 TNT 35-65; Brett Cohen and Reto Micheluzzi, Lifting the Fog: Accounting for Uncertainty in Income Taxes, Tax Notes, Oct. 16, 2006, p. 233, Doc 2006-20362, 2006 TNT 200-33.
unit of account. The example involves four research projects. The company determines that each project should be viewed as a separate unit of account. That determination is based on the size of each research project, the determination that a taxing authority would probably approach the audit on a project basis, and the company s information reporting, which is on a project basis. Presumably, under other circumstances the research projects could be combined into one unit of account or the research expenditures could be viewed on a functional basis and not on a project basis. Second, for each unit of account, the company is directed to determine if allowance of an uncertain tax benefit is more likely than not a typical tax opinion standard. The tax opinion issuer must assume that all the facts are known, all possible legal and factual arguments are made by the best litigants, and the issue is decided by a court of last resort. It should be noted that this legal, opinion-based analytical process operates cleanly for legal questions, which have an all-or-nothing quality. Factual issues such as valuation or section 482 transfer pricing adjustments do not fit well into the classic opinion mode of analysis, but those types of issues may be more comfortably addressed in a FIN 48 context, as discussed below. In resolving the initial question of whether allowance of the tax position is more likely than not, the company is to assume that the tax position will be examined by the relevant taxing authority that has full knowledge of all relevant information. Moreover, each tax position must be evaluated on its merits without considering the effects of possible offsets or aggregation with other positions. The final step creates the greatest uncertainty in the application of FIN 48. Once a tax position satisfies the more likely than not standard, the tax position must be measured. The measure prescribed by FIN 48 is the largest amount that is greater than 50 percent likely to be realized on ultimate settlement. Thus, measurement under FIN 48 considers the amounts and probabilities of outcomes that could be realized on ultimate settlement. - 2 -
Examples of probability-based approach are in paragraphs A19-A30 of FIN 48. Interest and potential penalties are included as part of the FIN 48 measurement process. 2 FIN 48 does not apply to immaterial items. FIN 48 also contains detailed rules regarding the disclosure of recognized and unrecognized tax benefits. Disclosure is required on a gross basis, not on an issue-by-issue basis. The FIN 48 workpapers, however, would show each uncertain tax position separately. II. Some Issues Involving Application of FIN 48 A. Is Settlement the Only FIN 48 Possibility? FIN 48 suggests, somewhat unhelpfully, that most cases are settled, not litigated to final conclusion. It then states that as a result, the measurement of the tax position is based on management s best judgment of the amount the taxpayer would ultimately accept in a settlement with taxing authorities. FIN 48 also states that the measurement of an uncertain tax benefit comes about when it is likely that the issue will be settled for less than the full amount of the benefit. FIN 48, para. A23. The discussion in FIN 48 of the settlement possibility leaves several questions unanswered. First, and most importantly, does FIN 48 require a settlement assumption in every case? By its terms, FIN 48 does not seem to preclude the possibility that, for a particular issue and taxpayer, litigation may be the only possible result. The reference to a likely settlement leaves open the possibility that FIN 48 does not require the settlement assumption in every case. Suppose a company is committed to litigation of an uncertain tax position. (Some possible reasons for such a commitment are discussed below.) That would mean, at least arguably, no reduction in a claimed uncertain tax benefit under FIN 48. The reason is that, by definition, if a favorable result in litigation is more likely than not to occur and a taxpayer is committed to litigation, there should be no reduction in a claimed but uncertain tax benefit. While it is possible to read FIN 48 as requiring that the company 2 For a specific discussion of some interest-related issues under FIN 48, see Rogers and Andrews and Urban and Throndson, supra note 1. - 3 -
assume that all uncertain tax matters are settled, there is also support for a committed to litigation alternative. 3 The result under either approach (that is, either committed to litigation or mandatory settlement) can probably be considered anomalous at least in part. For example, assume that FIN 48 requires a mandatory settlement approach and that there is a legal issue that is 70 percent in favor of the taxpayer. If the uncertain tax issue will in fact be litigated, it will either be won or lost, but there is still a 70 percent accrual of the uncertain tax benefit under FIN 48, a result that could not possibly be achieved ultimately in litigation. Note also that the mandatory settlement assumption works well for a valuation issue, but it creates problems when there are pure legal issues for which litigation is likely (or certain). However, FIN 48 might reasonably be interpreted to permit a committed to litigation approach. In that event, if the company happens to have 10 uncertain issues, each of which is 70 percent in favor of the company and each of which is committed to litigation, the taxpayer would expect to win seven and lose three. Still, each issue on its own is more likely than not to be won. Consequently, there would be no FIN 48 reserve on all 10 issues because each issue must be viewed separately and each is more likely than not to be won. We also know well, of course, that uncertain tax issues committed to litigation are frequently settled on the eve of trial. Thus, the committed-to-litigation concept appears to have a chimerical quality that undermines its attractiveness. The reasons for a commitment to litigation are many and varied. In some cases, a taxpayer would be willing to settle at 70 percent but the IRS has designated an issue for trial. For that scenario, the committed-to-litigation concept results in no FIN 48 reduction for an uncertain tax benefit. Similarly, a taxpayer may be willing to settle at 70 percent but the IRS may not be willing to go that far. There might be an IRS global settlement offer, for example. In both of those situations, the taxpayer is committed to litigation even though he would willingly settle at a fair level. That seems odd. In the latter type of case, 3 See, e.g., Kimmelfield, supra note 1, at 503. - 4 -
in which the IRS is prepared to settle but the taxpayer hopes to get more, a settlement percentage approach seems to be sensible. Indeed, it might be preferable to require that an acceptable settlement level be used under FIN 48 in every case, regardless of whether or not the company is committed to litigation. B. A TAM Possible Magic Potion? The above discussion assumes that there are only two outcomes: a settlement that takes into account litigating hazards, and a court decision (which turns on a commitment to litigate) that is either win or lose. Suppose, however, that we consider a technical advice memorandum as a third option. A TAM resolves a matter administratively, so no litigation commitment is necessary and the resolution is based on the merits, not on litigating hazards. FIN 48 doesn t seem to recognize the possibility of the third alternative. A cynic could argue that if the issue is more likely than not to favor the taxpayer, the IRS should always rule favorably on a TAM. Indeed, there are many pro-taxpayer TAMs. Hence, if the TAM possibility is reflected in the FIN 48 process, all more likely than not positions would be exempt from any cutback without regard to the prospects for or commitment to litigation. The TAM possibility, if properly recognized under FIN 48, avoids a hazards settlement and results in a 100 percent taxpayer result, thus eliminating any FIN 48 reserve on the issue. We doubt if that potential effect of seeking a TAM was considered or intended in a FIN 48 world. The TAM alternative applies only to legal issues. Fact issues are not subject to a TAM. Once again, FIN 48 appears to operate more smoothly for fact questions than for legal questions. Could it be that there should be different FIN 48 rules for legal issues than for factual issues? C. Multiple Argument Issues The IRS often makes several arguments. Those arguments frequently proceed from independent bases, such as partnership antiabuse rules, step transaction issues, and business purpose designations. If the taxpayer has a 75 percent argument on each of those three issues, the probability of winning the case is 27/64, or a little more than a 42 percent - 5 -
chance of winning. Thus, despite having the best of each distinct position, the uncertain tax benefit at least arguably fails the more likely than not standard it is not more likely than not to survive. That seems dubious. A pragmatist would argue that the issues are not really independent 4 and that, in any event, the IRS does not settle issues in that way. If the IRS has several weak arguments, a settlement giving the IRS 25 percent of what it s seeking is almost certainly acceptable even though, analytically, it could be at a much lower level provided all the IRS arguments are truly independent. To prevail, the company would have to win all three arguments. The right answer in practice may be different from the right answer in theory. It is uncertain exactly what FIN 48 requires in those circumstances. D. Road Map Problem and Policy of Restraint One of the most controversial aspects of FIN 48 is the potential for disclosure of the company s FIN 48 workpapers. That issue is acknowledged and addressed in FIN 48. The IRS currently has a policy of restraint on requesting tax accrual workpapers, with recently created exceptions for certain transactions. The IRS s policy of restraint, however, is under review. 5 It may be that, on large matters, the IRS will change its view and begin to ask for FIN 48 workpapers. The IRS s policy of restraint applies only to workpapers. But what about issue spotting? It seems likely that the IRS will begin to ask taxpayers to reveal the uncertain tax positions included in their FIN 48 workpapers not necessarily the workpapers themselves, just an identification of the issues. Issue disclosure is less of a problem than workpaper disclosure, but there can be circumstances in which disclosing an issue also discloses the taxpayer s view of settlement. Thus, if there are five small issues and one big issue, it may not be difficult to figure out the company s view of settlement prospects for the big issue. 4 In Smith v. Commissioner, 78 T.C. 350 (1982), the first big straddle case, the IRS argued on sham, economic substance, common-law wash sale, at-risk, and profit motive grounds. The IRS prevailed on the profit motive argument. Most of those arguments, at least in our view, are independent. 5 See reported comments in Sheryl Stratton, FIN 48 Leading IRS to Reconsider Restraint Policy for Workpapers, Tax Notes, Feb. 12, 2007, p. 614, Doc 2007-3480, 2007 TNT 28-3. - 6 -
E. Privilege There are myriad privilege issues. A simplistic view suggests that, if a tax attorney gives written FIN 48 advice to the company and the advice is then provided to the independent accountants, privilege disappears for both the attorney-client privilege and the work product doctrine. We suspect there are a lot of reasons why that view if debatable. F. Foreign Related Issues FIN 48 may have important effects in a multinational context. Consider the following issues. 1. Section 482: transfer price adjustments. Section 482 transfer price adjustments seem to be a good area in which to consider the FIN 48 requirements. There is no single correct transfer price, so some section 482 adjustment is always possible. The competent authority process is supposed to resolve those multinational problems to prevent double taxation, but interest can be a problem even in the competent authority process, and sometimes the competent authorities don t agree. Of course, there can also be circumstances in which the foreign jurisdiction does not have a FIN 48 concept, so the financial books in the two countries will not match. Presumably, a comparison of the two sets of books would shed light on the company s FIN 48 positions. 2. Road map via foreign request for treaty assistance. In a treaty context, a foreign country can ask for information assistance from the U.S. That can lead to several issues. For example, if the foreign country asks for FIN 48 workpapers, will the IRS obtain them to fulfill the foreign country s treaty request? If the foreign country obtains them, will the IRS continue to have a policy of restraint? 6 6 See Audrey Nutt, IRS Admits to Sharing APA Information With Treaty Partners, Tax Notes, Feb. 5, 2007, p. 503, Doc 2007-2693, 2007 TNT 23-3. - 7 -
G. No Justice Department Policy of Restraint There is no similar policy of restraint at the Justice Department for tax accrual workpapers. Justice is apparently willing to ask for tax accrual workpapers. The Textron case involves this issue. 7 If Justice obtains FIN 48 workpapers, will they be released to the IRS or will they be kept from the IRS? H. Settlement Percentages May Exceed 100 Percent One of the more interesting of the oversimplifications in FIN 48 is the premise that the taxpayer s various settlement options must always sum to 100 percent. They don t or at least they might not in some circumstances depending on how one interprets FIN 48. Here s an example to test that point. Assume there is a tax deferral situation. A company claims on its tax return accelerated deductions in years 1, 2, and 3 and gives the accelerated deductions back in years 4 through 10. It s all even after 10 years. Let s assume the company has a strong legal argument that the deferral is permitted, but allowance is uncertain. Let s assume the taxpayer has a 70 percent chance of prevailing. One way to settle the issue with IRS Appeals would be to give up 30 percent of the tax deferral for each of the first three years, but make correlative adjustments to the restoration amounts over years 4 through 10. Consider, however, another settlement that might have the same present value but potentially different FIN 48 consequences. The company might agree to keep the years 1 and 2 deferrals but to surrender the year 3 deferral in full. Thus, no tax adjustment is made to years 1 and 2, but the larger adjustment in year 3 is roughly equivalent to a 70-30 settlement. Assume that it s more likely than not that the year 3 settlement alternative would be acceptable to the IRS. Does that suggest that there is no uncertain tax position in year 1? (It is more likely than not that the settlement with IRS Appeals will result in no year 1 adjustment.) A taxpayer might be equally likely to agree to keep the first three years deferral but to surrender all of the remaining deferral in year 4, not years 4-10. That settlement might be better for the IRS than 70-30 in the first three 7 United States v. Textron, Case 06 198T, United States District Court for Rhode Island, filed April 28, 2006, Doc 2006-8274, 2006 TNT 84-19. See also Doc 2006-15281, 2006 TNT 157-91 (Textron brief seeking denial of summons enforcement), and Sheryl Stratton, Privilege Panel Covers Transparency, Textron, FIN 48, Tax Notes, Nov. 13, 2006, p. 617, Doc 2006-22569, 2006 TNT 214-3. - 8 -
years. As long as FIN 48 does not mandate a simple 70-30 settlement for each year, the number of potential settlement options is enormous. It should also be noted, as explained above, that FIN 48 precludes a consideration of offsetting or aggregating positions. Is that what is involved here, when the company takes a single issue and considers a potential settlement over a period of years and there is a reasonable possibility that the IRS would accept that approach? In short, there is uncertainty whether the settlement percentages will always add to 100 percent in the simplistic way contemplated by FIN 48. I. Assumed IRS Knowledge: How Expansive? FIN 48 states that you must assume an IRS audit will occur and that the IRS has knowledge of all relevant information. That leaves open some questions. Does it mean the IRS examiner must be assumed to audit the particular uncertain tax issue involved? For example, a particular tax issue may be one that the IRS would not normally review. In a given case, there may have been several audit cycles and the tax issue may never have been reviewed. Also, does FIN 48 require an assumption that all relevant legal arguments will be made? Or does the assumption of all relevant information mean only factual information? The second FIN 48 question regarding settlement prospects is designed to mirror reality, which is why it incorporates a probable settlement, not litigation. The reality is that many potential legal theories are not advanced. In a classic opinion context, which is the first step under FIN 48 for determining whether a tax position is more likely than not, all legal and factual issues are raised and are assumed to be fully and perfectly argued. Is that also the case in the measurement step of FIN 48? If so, FIN 48 should be clarified. Thus, FIN 48 could address a situation in which there is a potential legal argument that could be made by the IRS but that probably will not be made. J. Reduction of FIN 48 Reserve After Audit Suppose there is an IRS audit and the company, on resolution of the audit, substantially restates its FIN 48 uncertain tax positions downward? That would suggest - 9 -
that the IRS audit missed an issue. Would that be grounds to open a second IRS audit? 8 Alternatively, in the next audit cycle, will the IRS be inclined to find out what happened to cause a change in the FIN 48 reserve? K. Valuation Issues Consider how the FIN 48 more likely than not standard operates in a pure valuation-type case. One example might be a charitable deduction. There is a simple valuation issue. Is it more likely than not that 100 percent of the charitable deduction would be allowed? In most cases, the answer is no. Is it more likely than not that some charitable deduction would be allowed? In most cases, the answer would be yes. It seems reasonably clear that FIN 48 would apply the more likely than not standard on a gross allowance level and that a pure valuation fight never (or very rarely) triggers a determination that the allowance of even $1 of deduction fails the more likely than not standard. One would have to conclude that it was more likely than not that the allowable charitable deduction was zero. That is not a likely result. In effect, therefore, the two levels of analysis normally involved in FIN 48 are conflated into one level when it is a purely factual issue, for example, a valuation issue. III. Conclusion This discussion suggests that the FIN 48 world is not yet highly developed. Presumably, over time, there will be guidance on these and other FIN 48 matters. 8 The potential for a second IRS audit, assuming that section 7605(b) is complied with, may suggest that the company should not change its FIN 48 position until the statute of limitations has expired. - 10 -