Legal and practical issues in applying FIN 48.

AuthorAndreoli, Brian E.

In June 2006 the Financial Accounting Standards Board (FASB) issued Interpretation No. 48 (FIN 48), which addresses accounting for uncertainty in income taxes? This article proposes a practical framework for implementing FIN 48. No single article, however, can address all of the uncertain tax positions (UTP), take into account the full complexities of an UTP, or account for the amount of resources each corporation may need to denote to the process.

Generally, companies will need to be in compliance with FIN 48 during the first quarter that is subject to FIN 48. For calendar year corporations, FIN 48 applies as of January 1, 2007. Corporations will need to bring the opening balance into compliance with FIN 48 as well as appropriately apply FIN 48 to events that generate new UTPs during the first quarter. Here is, first, a brief overview of FIN 48, then a discussion of implementation issues.

Overview

The validity of an income tax position taken on a tax return is a matter of law. It is not controversial to recognize the benefit to an enterprise when it takes a tax position in its financial statement with high confidence that the tax authority will sustain that tax position. In some cases, however, the law may be subject to various interpretations. Whether a tax position will ultimately be sustained may be uncertain.

Under FIN 48, all income tax positions (including foreign income tax positions) are evaluated under a two-step process. The first step is recognition. The enterprise determines whether it is "more likely than not" that a tax position will be sustained upon examination, including resolution of any related appeals or litigation, based on the technical merits of the position. In considering the merits of a tax position, the enterprise must assume that the tax authority will have full knowledge of all relevant information when it examines the tax position. In the recognition step, it is necessary to evaluate the technical merits of each tax position (other than immaterial items). It is also necessary to determine the appropriate "unit of account" for a tax position. In making this determination the enterprise should consider the manner in which it prepares and supports its tax return, as well as the anticipated approach the tax authority will take during an examination.

The second step is measurement. A tax position that meets the "more likely than not" recognition threshold is measured to determine the amount of benefit that should be recognized in the financial statement. The tax position is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information using the facts, circumstances, and information available at the reporting date. This definition raises a broad range of issues.

Implementation

FIN 48 must be applied to all tax positions upon initial adoption. Only tax positions that meet the "more likely than not" recognition threshold may be recognized or may continue to be recognized. The cumulative effect of applying FIN 48 must be reported as an adjustment to the opening balance of retained earnings. Accordingly, calendar-year taxpayers will need to make this adjustment as of January 1, 2007. As such, an analysis of the opening balance may result in either an adjustment to retained earnings and to the Deferred Tax Accounts (DTA) or it may, in rare events, lead to a Restatement. (2) Since the basic premise of FIN 48 is that there had not been a consistently applied standard for the recognition of a tax position, it is possible that many corporations will need to adjust retained earnings. For example, retained earnings might be increased if prior audits required significant reserves even in regard to UTPs with a "should" level of opinion.

  1. Undertaking and Documenting a Process that Identifies Material Tax Positions

    In general corporations should be prepared to identify potential UTPs. These would include transfer pricing, jurisdictional taxation issues (whether international, federal or within the state tax context), the claim of credit or the election of alternative tax positions, issues concerning the acquisition, disposition, dissolution or formation of legal entities, issues concerning the expensing and capitalizing of items, and the myriad other possible uncertain tax issues that may be relevant to a particular taxpayer.

    Companies will need to develop and document an internal process that reliably identifies material income tax positions on a global basis. Once material historic income tax positions are identified, new material tax positions must be identified on a quarterly basis. The implementation of FIN 48 will require a one-time significant effort to identify all material tax positions.

    Thus, the first step is to develop and document an identification process for UTP. That process must be designed to identify all material UTPs. The taxpayer's independent audit firms will ask for the documentation of the process under section 404 of the Sarbanes-Oxley (SOX) Act. The process and execution is highly dependent on prior records. For most, the UTP list will have to be constructed by reviewing multiple sources. In general, existing reserve workpapers and the tax returns are a good source to...

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