FIN 48 – Accounting for Uncertainty in Tax Positions
May 12, 2008
McGladrey & Pullen LLP is a member firm of RSM International – an affiliation of separate and independent legal entities.
Course Outline
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Background/Basic Concepts
Recognition and Measurement
Special Rules
Examples
Financial Statement Disclosures
FIN 48 – Basic Concepts
McGladrey & Pullen LLP is a member firm of RSM International – an affiliation of separate and independent legal entities.
Uncertain Tax Positions – FIN 48
Why the Change?
• Diversity in practice of how tax positions were recognized in financial
statements
– FAS 109 did not address this issue
• Some of the practices included:
– Recording a “cushion” for the estimated liability resulting from final resolution of
the uncertainty
– Increasing the valuation allowance to reduce deferred tax assets for the
estimated effect of the uncertainty
– Establishing a confidence threshold for recognizing tax benefits and applying
the FAS 5 “probable” threshold for recording contingent losses associated with
those positions
Uncertain Tax Positions – FIN 48
Effective Date and Transition
• FIN 48 is effective for fiscal year beginning after December 15, 2007
– Early adoption permitted if company has not issued interim financial statements
for the year
• These rules must be applied to all open tax positions upon initial
adoption
• The cumulative effect of adopting FIN 48 is recognized as an
adjustment to beginning retained earnings
• SAB 74 disclosures regarding estimated future impact is required for
all financial statements issued by public companies before adoption
of FIN 48
Uncertain Tax Positions – FIN 48
What is a Tax Position?
• FIN 48 applies to all tax positions accounted for under FAS 109,
including (but not limited to):
– Position in a previously filed tax return or expected filing position that effects
current or deferred tax assets or liabilities for interim or annual period
– A decision whether or not to file a tax return
– A decision to exclude reporting income in a tax return
– Characterization of gains or losses as capital or ordinary
– Allocations of income between taxing jurisdictions
– Decisions to classify transactions or entities as tax exempt
Uncertain Tax Positions – FIN 48
Scope
• FIN 48 applies to income taxes only and does not apply to nonincome taxes such as property taxes, sales & use taxes, franchise
taxes based on capital, etc.
– On the other hand, FIN 48 has heightened the awareness as to liabilities for
these other taxes which are still subject to FAS 5
• FIN 48 applies to any entity that is potentially subject to income
taxes, including:
– Nonprofit organizations
– Flow-through entities (i.e., partnerships, S corporations, LLCs)
– Pass-through entities with 100% credit for dividends paid such as REITs and
RICs
FIN 48 – Recognition and Measurement
McGladrey & Pullen LLP is a member firm of RSM International – an affiliation of separate and independent legal entities.
Uncertain Tax Positions – FIN 48
Step #1 - Recognition
• Criteria for financial statement recognition of a tax position:
– More likely than not (more than 50%) the position will be sustained upon
examination (including appeals or litigation required to settle the matter)
– Based on the technical merits of the position
– Presume examination by relevant taxing authorities that have full knowledge of
all relevant information (i.e., no “audit lottery”)
– Evaluate each position without offset or aggregation
Uncertain Tax Positions – FIN 48
Step #1 - Recognition
• Technical merits are based on:
– Application of sources of tax law authority to facts and circumstances
• Includes legislation and statutes, legislative intent, regulations, rulings and
case law
• Highly recommended that auditors utilize tax professionals to examine and
evaluate technical merits of tax positions
– May rely on widely understood administrative practices and precedents of
taxing authority in dealing with similar businesses
• (e.g., fixed asset capitalization threshold)
• This exception should only be used when there is compelling evidence the
taxing authority will accept the position
Uncertain Tax Positions – FIN 48
Step #1 - Recognition
• Unit of account must be used to determine if more likely than not
(“MLTN”) threshold is met
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Based on how taxpayer prepares and supports tax return
Based on the approach anticipated to be taken by examining tax authorities
The unit of account can change based on a change in facts and circumstances
Example: unit of account for R&D credit may be projects or departments
Uncertain Tax Positions – FIN 48
Step - #2 - Measurement
• Measurement = determining the largest amount of tax benefit greater
than 50% likely to be realized upon settlement
– Based on expected negotiated settlement with taxing authority that has access
to all relevant facts
– Based on management’s best judgment given the facts, circumstances and
information available at the time
Uncertain Tax Positions – FIN 48
Measurement
• Example:
Possible Outcome
Ind. Probability %
Cumulative Prob. %
$100
5
5
80
25
30
60
25
55
50
20
75
40
20
95
20
5
100
Uncertain Tax Positions – FIN 48
Subsequent Recognition/Derecognition
• If MLTN threshold not initially met, tax benefit recognized in first
interim period that meets one of these conditions:
– The MLTN threshold is met
– The tax matter is resolved through settlement or litigation
– The statute of limitations has expired
• A previously recognized tax position is derecognized when it is no
longer more likely than not that the position will be sustained
– Use of valuation allowance is not permitted for this purpose
Uncertain Tax Positions – FIN 48
Change in Judgment
• Change in judgment based on new information can result in
recognition, derecognition or change in measurement
– Recognized as a discrete item in earnings in the period in which the change
occurs and does not affect the estimated annual effective tax rate
– If change occurs in different interim period of the same fiscal year as initial
recognition, then it is reflected in the estimated annual effective tax rate
FIN 48 – Other Special Rules
McGladrey & Pullen LLP is a member firm of RSM International – an affiliation of separate and independent legal entities.
Uncertain Tax Positions – FIN 48
Interest and Penalties
• Interest on underpayments should be recorded in the first interim
period that interest would begin accruing by applying the statutory
interest rate to the difference between tax position recognized in the
financial statements and the amount claimed on the tax return.
• If a tax position does not meet the minimum threshold to avoid
penalties, an expense must be recognized in the period the company
expects to claim the position in the tax return.
Uncertain Tax Positions – FIN 48
Deferred Tax Impact
• FIN 48 applies to temporary differences as well as permanent
differences
– Computation of temporary differences are based upon tax effect of MLTN tax
basis versus financial statement basis of assets and liabilities
– The tax effect of difference between MLTN tax basis and “as filed” tax basis
should be recorded as a reserve in income taxes payable
Uncertain Tax Positions – FIN 48
Classification of Liability
• Liabilities arising from the difference between the tax treatment and
the financial statement measurement of the tax benefit is recorded
based upon expected cash payment
– Payable within one year or operating cycle - current tax payable
– Payable in excess of one year - non-current tax payable
Uncertain Tax Positions – FIN 48
Classification of Liability
• Interest and penalties may be classified as either income tax
expense or interest expense based on accounting policy elected by
management
• If interest is classified as income tax expense, the interest will need
to be recorded net of the tax benefit, since the interest is tax
deductible
FIN 48 - Examples
McGladrey & Pullen LLP is a member firm of RSM International – an affiliation of separate and independent legal entities.
Uncertain Tax Positions – FIN 48
Example – Permanent Difference
• Research credit claimed on return = $1,000,000
• Unit of account = 4 projects at $250,000 each
• Projects 1,2,3 meet MLTN threshold, project 4 does not
– Potential recognition = $250,000 x 3 = $750,000
• Largest settlement more than 50% likely is $250,000 for project 1
and $200,000 each for projects 2 and 3
– Initial measurement $250,000+$200,000+$200,000 = $650,000
Uncertain Tax Positions – FIN 48
Example – Permanent Difference
• Journal entry to record uncertain tax position benefit:
– Current tax receivable
$1,000,000
Current income tax expense
Non-current income tax payable
$650,000
350,000
• Assume the credit is later settled at $700,000, the entry would be as
follows:
– Non-current income tax payable
Current income tax expense
Cash (payment to IRS)
$350,000
$50,000
300,000
Uncertain Tax Positions – FIN 48
Example – Taxable Temporary Difference
• Acquired intangible asset of $150,000
– Indefinite book life
– Tax return filing position – entire cost deductible in year 1
– 40% likely to sustain immediate deduction; 60% likely to obtain sec 197 15
year amortization
• Largest settlement more than 50% is 15 year amortization
– Initial measurement in Year 1 = $150,000 / 15 = $10,000 x 40% = $4,000
– Additional benefits in years 2-15 of $4,000 per year
Uncertain Tax Positions – FIN 48
Example – Taxable Temporary Difference
• At end of Year 1 record deferred tax liability for difference between
book basis and the MLTN recognized tax basis ($150,000 – $10,000
= $140,000)
– $150,000 – $140,000 = $10,000 x 40% = $4,000
• The company will still claim a $150,000 deduction on the tax return,
so they will need to record a current tax receivable of $60,000
• Where does the difference of $56,000 go to balance the entry?
Uncertain Tax Positions – FIN 48
Example – Taxable Temporary Difference
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Journal entry to record uncertain tax position benefit:
– Current taxes receivable
Deferred tax expense
Non- Current tax liability
Deferred tax liability
Current tax benefit
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$60,000
4,000
$56,000
4,000
4,000
In year two, the entries would be as follows:
– Non-current tax liability (reserve)
Deferred tax expense
Current tax benefit
Deferred tax liability
$4,000
4,000
$4,000
4,000
Uncertain Tax Positions – FIN 48
Example – Taxable Temporary Difference
• Assume the issue is settled with the IRS after Year Five and the IRS
prevails and requires 15 year amortization
• Cumulative balances should be as follows:
– Deferred tax liability
– Non-current tax payable (reserve)
$20,000
$40,000
• Since the taxpayer deducted $150,000 and should have only
amortized $50,000; the payment owed to the IRS is $40,000
($100,000 x 40%)
Uncertain Tax Positions – FIN 48
Example – Taxable Temporary Difference
• The entry to record the settlement would be as follows:
– Noncurrent income tax payable
Cash (payment to IRS)
$40,000
$40,000
• In future years, there should be a current amortization deduction
taken in the provision and the return, so the entry each year in the
future will be as follows:
– Current income tax receivable
Deferred tax expense
Current tax benefit
Deferred tax liability
$4,000
4,000
$4,000
4,000
Uncertain Tax Positions – FIN 48
Examples – Temporary Difference
• The preceding example did not take into account:
– Interest and penalties
– Any financial statement impairment or write-down of the intangible
– The fact that a deferred tax liability related to an indefinite lived asset cannot be
offset against any deferred tax assets for purposes of determining valuation
allowance
Uncertain Tax Positions – Fin 48
Temporary Differences
• Another way to look at this is to maintain two parallel sets of deferred
tax roll-forwards
– Roll-forward #1 will track the differences between the book basis and the “as
filed” tax basis; in other words, what FAS 109 already requires, pre-FIN 48
– Roll-forward #2 will track the differences between the book basis and the “more
likely than not” tax basis that may be recorded under FIN 48
• The difference between deferred taxes computed under Rollforward
#1 and Rollforward #2 will be the reserve in current or non-current
income taxes payable
Uncertain Tax Positions – Fin 48
Temporary Differences
• The Parallel Rollforward method has several advantages
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Easier to track differences and maintain integrity of deferred tax computations
Enables provision to return reconciliation more easily
Better SOX 404 controls
Entries recorded on a gross basis; making it easier to reconcile tax accounts
Uncertain Tax Positions – Fin 48
Temporary Differences
• For example, the initial entry in the taxable temporary difference
example under the parallel rollforward approach would be as follows:
– Current tax receivable
$60,000
Deferred tax expense
60,000
Deferred tax liability
Current tax expense (benefit)
To record as-filed tax benefit of acquired intangible
– Deferred tax liability
$56,000
Current tax expense (benefit)
56,000
Non-current tax payable (reserve)
Deferred tax expense
To record reserve for uncertain tax position
$60,000
60,000
$56,000
56,000
FIN 48 – Financial Statement Disclosures
McGladrey & Pullen LLP is a member firm of RSM International – an affiliation of separate and independent legal entities.
Uncertain Tax Positions – FIN 48
Required Disclosures
• The accounting policy regarding classification of interest and
penalties
• Tabular reconciliation of unrecognized tax benefits, including:
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Beginning balance
Gross additions/reductions to UTP liability from prior period tax positions
Gross additions/reductions to UTP liability from current period tax positions
Decreases resulting from settlements with tax authorities
Decreases resulting from the lapse of the statute of limitations
Changes in interest and penalties, if classified as income taxes
Ending balance
Uncertain Tax Positions – FIN 48
Required Disclosures
• The total of uncertain tax positions that, if recognized, would impact
the effective tax rate
• For items where it is reasonably possible the estimate of the realized
tax benefit will materially change in the next 12 months:
– Nature of the uncertainty
– Nature of the event that could cause the change
– Estimated range of reasonably possible change
Uncertain Tax Positions – FIN 48
Required Disclosures
• The amount of interest and penalties recorded in the income
statement and balance sheet
• A list of open tax years by major jurisdiction
• In the fiscal year of adoption, the cumulative effect of the change
recorded as an adjustment to retained earnings
Uncertain Tax Positions – FIN 48
Sample Disclosures
• See FIN 48, ¶ A33 for narrative disclosure discussing tax jurisdictions
filed in, open years under the statute of limitations, IRS audit status
including the range of anticipated payments and interest and
penalties accrued
• The example lists transfer pricing and state nexus as the tax
positions with the greatest uncertainty and that adverse settlements
would significantly impact the effective tax rate
• The example also shows a sample reconciliation of the liability
(reserve) for uncertain tax positions
Questions?
Call to speak with one of the local
RSM Tax Professionals at
619.280.3022
E-mail me: Erica.Costanzo@rsmi.com