Background

See, in general, August, “Understanding FIN 48: Accounting for Uncertainty in Income Taxes, Business Entities” (WG&L), May/Jun 2008

"FIN 48 clarifies the guidelines for accounting of uncertainty in income taxes on financial statements of enterprises per FASB Statement No. 109, Accounting for Income Taxes, and removes uncertain income tax positions from the guidance provided under FAS 5, Accounting for Contingencies. It also applies to purchase accounting in connection with a business combination. Use of a valuation allowance described in FASB Statement 109, therefore, is not an appropriate substitute for the derecognition of a tax position. The requirement to assess a valuation allowance for deferred tax assets based on the sufficiency of future taxable income is left unchanged by FIN 48. This situation would arise, for example, where a company with a large NOL carryforward is not likely to produce a sufficient level of future taxable income to fully utilize the NOL within the applicable carryover period.

When a position is taken on a tax return that reduces the amount of income taxes payable even though another interpretation of current law can be made that would not reduce current income taxes payable, the enterprise realizes an immediate economic benefit. Under FIN 48, this benefit of a favorable tax position can be recognized in the current period when the position has a more likely than not (MLTN) chance of being upheld through court review despite the presence of contrary interpretations, and the benefit to ultimately be realized can be measured in accordance with applicable rules. Only the difference between the measured benefit and the reported benefit on the tax return is required to be added to the tax reserve. On the other hand, if the position on a particular item, i.e., a so-called “unit of account,” is determined to be less likely than not correct, the full amount of the tax liability, as well as projected interest and possible penalty, must be included in the reserve as a current liability (or reduction in the NOL carryforward or claimed tax refund) where the company anticipates making payment within one year or within the company's next operating business cycle. Non-current liabilities for fully or partially unrecognized tax positions are treated as a deferred tax liability to the extent unrecognized. Such book-tax adjustments will, in certain instances, affect the tax basis of one or more assets thereby differentiating book from tax depreciation - during the applicable recovery periods.

In many instances, partial or totally unrecognized tax positions may not later be derecognized, i.e., reduce the amount of the reserve or liability for uncertain taxes, until the statute of limitations has expired for the year in which the position was taken and the position has not been challenged by the taxing authority. Conversely, previously recognized tax positions that subsequently fail the MLTN recognition standard due to an intervening change in the law are required to be derecognized and charged to liabilities in the first subsequent financial reporting period in which such determination is made.

Where the MLTN standard is not satisfied, no economic benefit may be claimed and recognized for financial accounting purposes, i.e., a liability is booked or reflected on the financial balance sheet for the total amount of tax due, plus associated interest and penalties.

Impact of FIN 48 on Reporting Companies and Privately Held Companies Preparing Financial Statements under GAAP.

In June 2006, FASB approved the final version of FIN 48 for generally accepted accounting reporting principles with respect to uncertain tax positions. FIN 48 is effective for fiscal years beginning after 12/15/06 for public companies, and for fiscal years beginning on 1/1/07 for non-publicly traded or privately held calendar-year companies. Originally, the same 2006 effective date was to apply to all entities using generally accepted accounting principles (GAAP) for financial accounting purposes. However, based on a recommendation of the Private Company Financial Reporting Committee, in November of last year, FASB agreed to delay the effective date until tax years beginning on 1/1/08 for private companies to comply with FIN 48. Again, it is critical to recognize that FIN 48 applies not only to companies whose shares of stock are publicly traded and therefore are registered with the Securities and Exchange Commission in reporting “fair value” filings, but also to all entities and enterprises who report financial results under GAAP. The scope of FIN 48 extends to all entities that use the GAAP method for financial accounting purposes, including tax exempt organizations and pass-through entities.

In setting forth this new and higher GAAP standard, FASB required reporting companies to recognize on their financial statements the best estimate of their tax positions. In abandoning the prior calculus of whether a tax item would probably, or find it reasonably possible, or remotely possible to survive IRS review, FIN 48 establishes a “recognition” or “non-recognition” approach. In order for a tax position to be “recognized,” it must have a more-likely-than-not chance of being sustained on the merits through audit, administrative, and judicial review. Once a position passes this threshold, and as further discussed below, the expected benefits are subject to a set of measurement rules and principles to quantify whether part or all of the benefit is to be recognized.

FIN 48 provides a detailed set of principles and applicable rules in determining how to treat such uncertain tax items, referred to as “units of account,” and sets forth a two-step process to recognize and measure a tax position taken or expected to be taken on a tax return. FIN 48 is divided into various categories or segments, including guidance on the subjects of recognition, derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. In general, differences in financial and tax accounting with respect to uncertain tax items will result in: (i) an increase in a liability for income taxes payable or a reduction of the amount of an anticipated income tax refund; and/or (ii) a reduction in a deferred tax asset or increase in a deferred tax liability.

FIN 48 applies to “tax positions” contained in a previously filed tax return or a position that will result in a permanent reduction in taxes currently payable or a deferral of income taxes to be paid until a future year. The tax liability for uncertain tax positions under FIN 48 is not included in the general label of deferred taxes. Rather, it must be classified separately from other tax balances based on the expected timing of cash flows to or from taxing authorities.

The term “position” includes: (i) an allocation or shift of income between jurisdictions, i.e., intercompany pricing agreements under Section 482; (ii) the characterization of income or a decision to exclude reporting taxable income, e.g., an assumed tax-free reorganization transaction without the presence of taxable “boot” or gain recognition; (iii) a decision to classify a transaction, entity or other position contained in a tax return as tax exempt; and (iv) a decision not to file a tax return, for example, in a foreign jurisdiction based on the assumed correctness that such income is not taxable.

If management, on its review and analysis, determines that the position will MLTN be sustained in the event of audit by the IRS or judicial review of an IRS challenge, such position can be currently recognized for financial accounting purposes as well. Still, a prior recognized position must be charged or reduced by the probable point at which the tax position will be resolved between the taxpayer and the IRS or applicable authority, as will be explained below. Correlatively, if the tax position taken on a tax return is not MLTN correct, it cannot be recognized for GAAP purposes and the underlying amount of tax, interest, and possible penalties must be booked as a deferred tax liability for the “uncertain item.” The liability may be eliminated when a tax position that was originally derecognized for GAAP purposes is favorably resolved, e.g., the running of the applicable statute of limitations for the return year in which the tax position was reported. FIN 48 applies to all U.S. income tax, as well as foreign, state, and local taxes (including franchise taxes) based on income. It does not apply with respect to sales and use taxes, value-added taxes, and other taxes not based on income. "

It is obvious that FIN 48's calculus is complex, time consuming and burdensome from a cost standpoint, Applied to public companies some may say it is far better than the uncertain and ambiguous prior applicable standard which elevated the reporting entity's tax audit experience perhaps over the substantive law and application of the facts in recognizing and measuring contingent tax liabilities. Some, however, have felt that private companies were not equipped to handle the costs and burdens of compliance, particularly for small (based on economic size) private companies and tax-exempt organizations.

Recent Efforts of Financial Accounting Standards Board to Reduce Burden of Smaller Entities in Accounting for Uncertain Tax Positions

The tax press has over the past few months chronicled the efforts of the Financial Accounting Foundation (FAF), which oversees FASB's operations, decided to establish the Private Company Council (PCC) to act as the primary advisory group on private company matters related to FASB's rulemaking agenda and to review existing standards to determine their relevance for private companies.  This was endorsed by the FASB Chair Leslie Seidman .

At a November 12 conference hosted by Financial Executives International, Seidman reiterated support for working with the PCC in evaluating the complexity and cost concerns regarding FASB's rulemaking. The PCC will hold its inaugural public meeting on December 6. There have been members of the accounting profession as well as the former advisers to the IRS that have made several recommendations to reduce the burden of FIN 48 compliance on small private companies. Due regard, of course, must be given to the uncertain tax position filing for federal income tax purposes which does not incorporate the FIN 48 approaches of “recognition” and “measurement” and is far simpler in scope and content but still is designed to notify the government of “soft spots” that may exist on the tax return.

It is expected that the PCC will recommend changes to GAAP under the FIN 48 rules for “small private business” entities, which would require the endorsement by FASB. It should also be noted that some of the largest companies in the U.S. are privately owned. Would they be included in the forthcoming recommendations despite having the resources to adhere to FASB rulemaking as public companies?  

Review of FIN 48 Implementation

Earlier this year, the FAF disclosed its post-effective date review of FIN 48 and concluded the standard was in fact achieving its stated purpose of improving financial reporting of income tax uncertainties and at an acceptable cost.  Some comments have been reported in the tax and financial press that the “post-implementation review was a superficial exercise that was "highly dependent on input from accounting firms and others having self-interest in perpetuating the complexity and compliance costs associated with FIN 48." Questions have also been raised as to the process that the FAF used to arrive at its conclusions regarding private companies because the post-implementation review of FIN 48 was inconsistent with the findings of the Private Company Financial Reporting Committee (PCFRC), a FASB advisory group that will be replaced by the PCC. The PCFRC has repeatedly suggested that FASB remove private companies from the group of constituents that must abide by the requirements of FIN 48.

FIN 48 disclosures obviously holds great interest for IRS auditors. While it presents contingencies for tax liabilities in summary form, there has been litigation over whether a taxpayer’s tax accrual work papers and underlying opinions and work product are discoverable in the event of an audit or litigation. FIN 48 disclosures are also carefully reviewed by financial advisors and their clients, and companies seeking to acquire target companies in a stock or merger acquisition.

It is important for accounting firms to keep track of this development as well as tax counsel who provides legal advise to clients that are subject to FIN 48 filings and record retention requirements.