FIN 48 compliance: disclosing tax positions in an age of uncertainty.

• Author: Hennig, Cherie J.

EXECUTIVE SUMMARY

* The interaction of FAS 109 and FIN 48 will result in greater public disclosure of tax planning techniques.

* Under FIN 48, a tax position is recorded only if the tax position is more likely than not to be sustained on examination (including related appeals or litigation processes).

* A material tax position is tested under a two-step process consisting of a recognition step and a measurement step.

* FIN 48 requires a reevaluation of all tax positions at the end of each reporting period. Prior recognized positions may be derecognized or remeasured, and prior positions may be recognized in each reevaluation.

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FIN 48 changes the way that much of the tax profession carries out its work, and it presents a number of difficulties in crafting disclosures of tax-related expenses, assets, and liabilities on U.S. financial statements. This article discusses the challenges involved with FIN 48 compliance and presents a comprehensive case study to illustrate the likely application of FIN 48 principles and their interaction with the new Schedule M-3 reporting requirements.

For financial statements prepared under U.S. generally accepted accounting principles (GAAP), the tax effects of the entity's operations have been governed by Statement of Financial Accounting Standards (FAS) No. 5, Accounting for Contingencies, and FAS No. 109, Accounting for Income Taxes. (1) Financial Accounting Standards Board (FASB) Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, a new interpretation of FAS No. 109 and APB No. 28 issued in July 2006, is effective for accounting years beginning after December 15, 2006. (2) This interpretation presents new challenges for taxpayers, auditors, and tax advisers. The disclosures required by the interaction of FAS 109 and FIN 48 will result in greater public disclosure of tax planning techniques, including the strengths and weaknesses of those techniques. (3)

FIN 48 is a response to the perceived public desire for greater transparency of financial data and is in part a result of the abusive tax-shelter activities of the 1990s and the financial accounting scandals of the early 2000s. (4) Questions arose regarding potential manipulation of reported earnings, including managing the effective tax rate reported in financial statements. (5) Furthermore, a large number of the material weaknesses and significant deficiencies initially reported under Sarbanes--Oxley were traceable to the construct of the entity's income tax expense. In the tax realm, regulatory responses to the perceived desire for greater financial transparency led to new Schedule M-3 reporting requirements for corporations and passthrough entities, (6) which require book-tax differences to be disclosed in two columns, one for temporary differences and one for permanent differences. Items disclosed in the temporary column should agree with items used to compute deferred tax assets and liabilities under FAS 109, while permanent differences should agree with items used to compute the effective tax rate.

Implementation of FIN 48 "lifts the veil" regarding tax strategies to an extent that may not be appropriate or healthy in the context of an adversarial, voluntary-compliance tax system.

Tax Strategies

Current tax planning strategies include:

* Establishing a set of financial goals;

* Developing a tax strategy as part of overall financial goals;

* Planning and executing a series of transactions aimed at managing tax liability;

* Reporting the results of the transactions on financial statements and tax returns;

* Separately subjecting these reports to review by financial and tax auditors;

* Justifying tax positions and, when necessary, revising financial reporting if required through SEC restatements; and

* Adjusting the tax liability after settlement of a tax issue through negotiation and (perhaps) litigation.

Final resolution of a transaction's appropriate accounting and tax reporting does not occur until long after the financial statements and tax returns have been prepared. In addition, the tax expense reported in the financial statements and the tax return may differ, requiring "true-up" adjustments after the tax return is filed. An entity cannot be certain as to the final reporting of certain transactions until an IRS audit is completed and any necessary adjustments are made. Thus, decisions regarding computation of the financial tax expense necessarily require the exercise of professional judgment regarding:

* Whether a tax return must be filed in various jurisdictions;

* How to claim and compute various income, deduction, and credit items;

* Whether the entity's status as an S corporation, controlled foreign corporation, or exempt organization has been maintained during the reporting year; and

* Whether IRS personnel and the courts will take exception to the taxpayer's tax return positions.

The financial accounting expense for income and other taxes can be both sizable and material on the financial statements and is likely one of the last accruals made when computing net income for the period. Before FIN 48 was issued, a taxpayer's required disclosure of the tax expense computation for the year was limited to a series of footnote discussions on the choice of tax accounting methods, policies, and various effective tax rates for the reporting year. The tax footnote discussed current-year settlements of tax audits, anticipated results of ongoing audits, and the potential expiration of any net operating loss (NOL), capital loss, and tax credit carryforwards.

The IRS could subpoena the entity's tax accrual workpapers, which likely include a listing of and computational projections for tax minimization techniques considered and applied in the tax year, as well as computational assumptions and conventions used to determine the current and deferred tax expense. In a welcome spirit of "playing fair" with its adversary the taxpayer, the IRS has shown restraint in obtaining tax accrual workpapers by rarely using its subpoena power. (7) The IRS recently announced that documents produced by a taxpayer or its auditors to substantiate the taxpayer's uncertain tax position in compliance with FIN 48 are considered tax accrual workpapers and will be subject to its current policy of restraint. (8) However, the IRS chief counsel reached the opposite conclusion regarding effective tax rate reconciliation workpapers because permanent timing differences between the statutory tax rate and the effective tax rate must be reported in the Schedule M-3. (9)

The Senate's Permanent Subcommittee on Investigations, chaired by Senator Carl Levin, sent a letter to at least 30 companies, asking for details on unrecognized tax benefits reported under FIN 48, as part of its investigation into corporate tax-cutting transactions. (10)

The application of FIN 48 greatly extends the amount and type of public disclosures by GAAP taxpayers. (11) This may affect the likelihood that a tax position will be challenged in an IRS audit, especially if additional disclosures reveal the strengths and weaknesses of positions taken on the tax return. (12) It is not an exaggeration to state that the scope of FIN 48's effects on the financial reporting and tax communities is the most extensive in memory.

FIN 48 Disclosures

When a taxpayer applies an exclusion, exemption, or credit to an item included in financial accounting income, FAS 109 accounts for the current tax reduction as a permanent difference from book income, which reduces the entity's effective income tax rate reported in the financial statement footnotes. Permanent differences affect the computation and disclosure of the current federal, state/local, and international effective tax rates. Temporary differences give rise to either a deferred tax liability or a deferred tax asset. When a deduction is accelerated or income is deferred from that allowed for financial accounting purposes, a deferred tax liability is created and reported on the balance sheet. When a deduction is deferred or income is accelerated from that recorded in the books, a deferred tax asset is created.

For every accounting year, the financial statements record changes in the entity's deferred tax assets or liabilities that are traceable to temporary differences between book and taxable income. Using FAS 109 terminology, the taxpayer likely prefers to create permanent tax differences so as to reduce the effective tax rate for the period and uses temporary differences to create and increase the deferred tax liability, because tax reductions improve the entity's cash-flow for the current reporting period.

Legitimate tax planning strategies include taking one or more tax return positions with which the IRS might disagree, potentially resulting in an audit adjustment and settlement through the appeals process or litigation. Entity tax departments and their tax advisers work to manage the tax liability in this way, taking supportable but taxpayer-friendly return positions and managing the risk of taking such positions in an appropriate manner. For financial accounting purposes, though, how does one account for these tax uncertainties? Should the tax return position be assumed to be fully correct such that the effective tax rate is reduced or the deferred tax benefit is recorded ha full in the current financial reporting period?

The basic rule of FAS 109 assumes that deferred tax benefits eventually will be fully realized. (13) For those items with some uncertainty as to their future realization, a valuation allowance is used to "write down" the deferred tax asset to an amount that more likely than not will be realized. Creation and maintenance of the valuation allowance entails the use of professional judgment by the tax adviser and the financial accountant to forecast the book and tax flow of future income and expense over time. To prepare for a possible audit of the valuation allowance, the entity...