FIN 48: insurance for when the IRS doesn't recognize what you did.

• Author: Blitz, Gary P.

Introduction

Publicly traded companies have been living with FIN 48 since the preparation of their financial statements for the first quarter of 2007. (1) The "uncertain tax position" standard embodied in FASB Interpretation No.48, "Accounting for Uncertainty in Income Taxes: An Interpretation of FASB Statement No. 109," is now a reality for corporate America across all industries. Nevertheless, FIN 48 continues to fill CFOs and tax executives with angst as they work to comply with accounting guidance that may have enhanced subjectivity and inconsistent reporting among companies in an attempt to increase transparency and level the playing field.

The potential for having to adjust a company's FIN 48 tax disclosures (and suffer an unexpected hit to earnings) when the IRS has the opportunity to weigh in has become a significant source of concern for financial executives that can be mitigated by a tax insurance product called "FIN 48 Insurance."

Uncertainty and Ambiguity

A mere two years ago, Credit Suisse, in its report titled Peeking behind the Tax Curtain, (2) summarized the problem in this way:

Corporate taxes are a giant black box for many investors. The combination of companies with multiple corporate entities being taxed in multiple jurisdictions (e.g., state, local, federal, and international) based on multiple sources of tax law (e.g., legislation, statutes, regulations, case law, etc.) is difficult enough to follow (e.g., General electric files over 6500 tax returns in over 250 global tax jurisdictions). Mix in the accounting for income taxes, which is arguably one of the least understood and most complicated areas in accounting, and it's no wonder that after fighting their way through a typical tax footnote even the most experienced investors have been known to cry out "No mas, no mas." Layer on top the fact that taxes are one of the larger costs that a company will incur, and you are asking for trouble. Credit Suisse predicted in 2007 that FIN 48 would result in more volatile effective tax rates and, consequently, more volatile earnings unless companies became more conservative in selecting which tax risks to undertake. It is still too early to know how or whether FIN 48 has influenced behavior, but FIN 48 has indisputably imposed upon boards of directors, CFOs, and tax executives a complicated and costly system for reporting income tax liabilities. Companies that take steps to mitigate their FIN 48 exposure, through expert analysis, insurance, or a combination of the two, will likely be looked upon more favorably by financial analysts and Wall Street.

What Is FIN 48?

In its desire for greater transparency and consistency among companies in their accounting for income tax liabilities, the Financial Accounting Standards Board in 2006 released FASB Interpretation No.48, "Accounting for Uncertainty in Income Taxes: An Interpretation of FASB Statement No. 109" (FIN 48). FASB's goal was laudable, but a complex framework had to be created in order to implement the new standard. Credit Suisse dubbed it the "FIN 48 Two Step," a two-pronged analysis of recognition and measurement that companies have to engage in with respect to every material tax position. Good and bad positions can no longer be offset in determining the proper level of reserving. Rather, companies must undertake an often subjective analysis of whether a position should be "recognized" for FIN 48 purposes. In an often confusing use of language, "recognition" means that a tax position has passed the FIN 48 tests and thus FIN 48 reserving and disclosure is not required. In other words, in FIN 48 parlance, a strong, supportable tax position is "recognized" but no FIN 48 liability has to be booked. The recognition threshold is more likely than not (MLTN), meaning that a determination must be made whether a position is "more likely than not" (3) to be sustained on challenge.

If the tax position passes the recognition threshold, a second determination--measurement--is required. The tax position is measured at the largest amount of benefit that is more likely than not to be realized upon settlement assuming the tax authorities have full information. If a position does not pass the two-pronged MLTN threshold, a company is required to post a reserve for the amount of estimated tax liability and make disclosures in its financial statements. The second prong is significant because a position could have to be recognized partially or in total if the amount is not supportable even though it is a winner based on the tax law. Then there is an ongoing requirement to update these determinations if a material change occurs.

Unfortunately, while disclosure has been enhanced, the rules still require many subjective judgments. There are varying interpretations among accounting and tax professionals and the financial and tax executives seeking to apply the accounting guidance. In addition, a public company has to balance its obligations to make truthful and full disclosure (subject to serious legal consequences under the securities laws and Sarbanes-Oxley) with concern over providing a roadmap to the IRS and other tax authorities. A recent article called "The Next Wave of Securities Litigation: FIN 48" (4) noted:

The "cards on the table" aspect of FIN 48 that itself changes the...