2008 Tax Conference
Michael Burak – PricewaterhouseCoopers
John Hildy – Mayer Brown Rowe & Maw
The views expressed in this presentation are not intended as, and should not
be relied on, as accounting, auditing, regulatory or tax advice. The outcome of
any independent situation depends on the specific facts and circumstances in
which the issue arises and on the interpretation of FAS 109 and other relevant
literature, laws and regulations in effect at the time.
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IRS Access
to Tax
Accrual
Workpapers
US Audit Environment
• FASB FIN 48 (2006)
– Provides structure for analyzing uncertain tax positions and, for
many filers, increases the level of detail behind tax reserve
analyses
• PCAOB AS3 (2004)
– Audit documentation must be sufficient to allow an experienced
auditor, with no prior connection to the audit, to understand
conclusions reached
• AICPA AU 9326 (revised 2003)
– Tax accrual and support are responsibility of client
– Where support is based upon an opinion of outside advisor,
auditor generally needs access to the opinion, notwithstanding
privilege claims
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IRS Environment
• Pressures surrounding
– Audit currency
– Resources
– Tax gap
• The IRS has authority to examine any books, records, or papers that
may be “relevant”
– Arthur Young (1984): US Supreme Court held that tax accrual
workpapers (“TAW”) were “highly relevant” to an IRS audit
• Tax accrual workpapers (“TAW”) can be an irresistible treasure trove
– TAW “Cadre” established within LMSB
– 6 hours of mandatory FAS 109 training
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Fluid IRS “TAW” Policy
• IRS historically has followed a self-imposed “policy of restraint” to
resist making blanket request for tax accrual workpapers
• In 2004, the policy of restraint began to weaken
– For “listed” transactions
• If taxpayer claims benefits from one disclosed “listed”
transaction, requests for TAW for that transaction are
mandatory
• If taxpayer claims benefits from one undisclosed “listed”
transaction, requests for all TAW are mandatory
• If taxpayer claims benefits from two or more disclosed “listed”
transactions, all TAW may be requested as a discretionary
matter
– Other transactions: requested in unusual circumstances
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IRS Definition of “TAW”
• IRS’s definition of “TAW” is broad:
“those audit workpapers, whether prepared by the taxpayer, the
taxpayer’s accountant, or the independent auditor, that relate to
the tax reserve for current, deferred and potential or contingent
tax liabilities, however classified or reported on audited financial
statements, and to footnotes disclosing those tax reserves on
audited financial statements. These workpapers reflect an
estimate of a company’s contingency analysis, tax cushion
analysis, or tax contingency reserve analysis.” IRM 4.10.20.2(2)
• Initially, IRS Chief Counsel advised this did not include ETR
reconciliation workpapers, but that advice was withdrawn
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Potential Defenses to Discovery
• Attorney-Client Privilege
• Section 7525 Tax Advisor Privilege
• Work Product Privilege
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Attorney-Client and 7525 Privileges
•
•
Applies to communications between attorney/tax advisor and client
intended to be confidential
– Communications must be for the purpose of providing legal advice
– Even 7525 must involve “lawyer’s work,” since there is no parallel
federal accountant privilege (Supreme Court in Arthur Young)
– Protects communications, but it does not protect facts
Waiver
– Waived on disclosure to any third party, including financial auditors
– Waiver to one party generally waives the privilege with respect to all
parties
– Waivers typically extend to all communications on same subject
matter
– Even describing the “gist” of communication is a waiver (e.g. “our
counsel gave us a favorable opinion on this issue”)
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Work Product Privilege
•
•
•
Protects materials prepared “in anticipation of litigation or for trial”
Courts interpret the “in anticipation” test differently
– First, Second Circuits: protects materials created “because of the
prospect of litigation”
– Fifth Circuit: protects documents where “primary motivating force
was to assist in possible future litigation”
– Some Circuits: articulation of the standard is somewhat ambiguous
Waiver
– Waived where disclosure is made to an adversary, or where the
disclosure makes it more likely that an adversary will obtain
document
• Cases discussing financial auditors are split:
– Textron, American Steamship, Jaffe, Merrill Lynch find no
waiver
– Medinol, Diasonics find waiver
– Waivers generally extend only to the items produced, not other
materials
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Case Study: Textron
• Textron was embroiled in a contentious IRS audit
– 7 of 8 past audits had gone to Appeals; 3 disputes resulted in
litigation
– Subsidiary had done 9 listed transactions (SILOs)
• IRS issued a summons for TAW of Textron’s consolidated group
– “Master” reserve schedules, plus supporting schedules, notes
and memos
– According to Textron, these TAW were prepared by in-house Tax
Department counsel and reflected their advice and legal
conclusions on the prospects of prevailing
– Textron had shown these TAW to its outside auditor (E&Y), but
had not allowed E&Y to keep copies
– E&Y had agreed to keep the information confidential
• When Textron refused to comply with the summons, IRS brought
suit in federal district court in Rhode Island
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District Court’s Holding
• Last August, the district court held that the workpapers were covered
by ACP/7525, but these protections had been waived upon
disclosure to E&Y
• But the court held the documents were protected as work product
– Applied controlling First Circuit test: whether the document was
acquired “because of” the prospect of litigation.”
• Ask: would the document have been prepared in
substantially the same form irrespective of the anticipated
litigation?
– District court held documents were prepared “in anticipation of
litigation”, applying a “but for” approach:
“If Textron had not anticipated a dispute with the IRS, there
would have been no reason for it to establish any reserve or
to prepare the workpapers used to calculate the reserve.”
– So the holding is that, by definition, all of the tax reserve
workpapers for all issues must be “in anticipation”
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District Court’s Holding (cont.)
• Moreover, court held disclosure to E&Y did not give rise to waiver of
work product privilege
– E&Y itself was not an “adversary,” despite its public watch dog
role
– Nor did the disclosure to E&Y increase likelihood that a true
adversary would subsequently obtain the documents
• E&Y had given assurances of confidentiality
• E&Y was under professional obligations to keep confidential
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Practical Implications
• The district court’s opinion is a great victory for taxpayers
• But be cautious…
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Practical Implications (cont.)
• It is, after all, a district court opinion
• IRS has appealed to Court of Appeals for the First Circuit
• Current status of appeal:
– Government opening brief (January 2008)
– Textron opening brief (March 2008)
– Amicus briefs supporting Textron (April 2008)
– Government reply brief (due May 5)
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Practical Implications (cont.)
• Attorney-Client and 7525 arguments are very difficult once
disclosure to auditor is made
– Textron has not even pursued these arguments in its brief
– This is true even if auditor does not keep copies
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Practical Implications (cont.)
• The work product holding was based on the First Circuit’s friendly
“because of” test
• In a Circuit that follows the less-friendly “primary purpose” test,
Textron likely loses
– The primary reason to create TAW is to compute and support tax
reserve, not to assist in litigation
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Practical Implications (cont.)
• This is the first opinion to extend work product protection to any
TAW, much less to all of them as a blanket matter
– Government’s brief:
• There is no work product protection for documents that are
prepared in the ordinary course of business or that would
have been prepared in the same form irrespective of litigation
– Textron’s brief:
• The workpapers were prepared “because of” the potential
dispute with the IRS
• If there had been no anticipation of litigation, there would be
no reserve
• The fact that TAW were also used for some secondary
business purpose (financial statement audit) does not forfeit
protection
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Practical Implications (cont.)
• The district court’s holding that Textron anticipated litigation rests on
factual determinations
– Is it credible to anticipate litigation on each and every item in
your reserve schedule?
• Is it true that, just because a taxpayer identifies a tax issue
and reserves accordingly, it “anticipates litigation”?
– More traditional facts supporting Textron’s claim:
• 7 of 8 cycles went to Appeals
• 3 went to litigation
• 9 listed transactions
• 500 IDRs
– Are there other consequences of anticipating litigation?
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Practical Implications (cont.)
• The district court’s holding that there was no waiver rests on factual
and legal determinations
– Facts:
• E&Y had agreed to keep materials confidential
• E&Y was bound by professional obligations of confidentiality
– Legal:
• Federal district courts are divided on the issue of whether
auditor is an “adversary”
• No appellate court has faced this issue
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Practical Implications (cont.)
• The decision does not protect information prepared by outside
auditors
– Government’s brief points out that its summons also sought
workpapers in possession of E&Y
• Government wants to make this argument because in Arthur
Young, the Supreme Court held tax accrual workpapers
created by audit firm were not protected as work product
– Textron’s brief:
• E&Y workpapers (if any) are irrelevant; we do not control
them
• IRS really wants the ones prepared by Textron’s attorneys,
which E&Y does not possess
• Too late to make that argument
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Questions
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Income Tax
Accounting
Update: The
Emergence
of IFRS
IFRS Overview – A Global Revolution
More than 100 countries require, permit or are converging to IFRS
Top 10 Global Capital Markets
Country
Standard
($ in trillions)
US
US GAAP
17.0
Converging to
IFRS
4.7
UK
IFRS
3.1
France
IFRS
1.7
Canada
Converging to
IFRS
1.5
Germany
IFRS
1.2
Hong Kong
IFRS
1.0
Spain
IFRS
1.0
IFRS or US
0.9
IFRS
0.8
Japan
Switzerland
Australia
Countries converging to IFRS with the goal of adoption
Countries that require or permit IFRS
Countries with no current plan to adopt
Source: Economist Intelligence Unit
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Reasonable timeline for the US
transition to IFRS
March 2007
SEC roundtable
on US GAAP
reconciliation for
IFRS filers
August 2007
SEC concept
release on use
of IFRS for US
companies
2009
2007
2008
July 2007
SEC proposal
eliminating
US GAAP
reconciliation for
IFRS filers
Between January
2009 and 2010
Potential voluntary
application of IFRS
permitted for US
companies
2011
2010
2012
November 2007
Reconciliation
eliminated
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2013
2015
2014
Between January
2013 and 2015
Potential mandatory
application of IFRS
by US companies
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Convergence
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Income Taxes Key Differences
and Short Term Convergence
IFRS
Tax base
Dependent on expected manner
of recovery or settlement of
asset or liability- Use, sale, use
and sale.
US GAAP
No definition of tax base
Tentative Convergence outcome:
The Board’s decided on a common definition of a tax base
IASB to eliminate requirement that management intent on recovery can affect
tax base
IASB decided to clearly establish that the tax base of an asset is determined by
the amount deductible by the entity if it sold or otherwise disposed on the asset
for its carrying amount at the balance sheet date.
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Income Taxes Key Differences
and Short Term Convergence
IFRS
Initial Recognition
Exemption
Prohibits recognition of a deferred tax
asset/liability for temporary differences
that arise from the initial recognition of
asset /liability in a transaction that:
–Is not a business combination
–At the time of the transaction affects
neither accounting nor taxable profit.
US GAAP
Does not provide this exception.
IAS 12 states explicitly that an entity does
not subsequently recognize changes in
this unrecognized deferred tax asset or
liability.
Tentative convergence outcome:
The IASB eliminated this exception.
Fair value of such assets and liabilities should be measured on initial recognition using the same
assumptions about the tax base that would be made by other market participants
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Income Taxes Key Differences
and Short Term Convergence
IFRS
Acquisition of
assets with a tax
basis not equal to
book basis
IAS 12 currently prohibits the
recognition of deferred tax on
initial recognition of an asset in a
transaction that is not a business
combination and does not affect
accounting or taxable profit.
US GAAP
No initial recognition
exemption;
Uses EITF 98-11
Tentative convergence outcome:
The IASB decided to eliminate the initial recognition exception.
The FASB decided to eliminate EITF 98-11
The Boards decided to move to a FV purchase discount model. It was concluded
that the deferred tax asset or liability should be recognised as the difference
between the fair value of the asset and its tax base multiplied by the tax rate. Any
difference between the consideration paid and the sum of the fair value of the asset
and the recognised deferred tax amount is recognised as a purchase discount
allowance on the deferred tax.
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Income Taxes Key Differences
and Short Term Convergence
IFRS
Tax rate
Enacted or substantively
enacted
US GAAP
Enacted
Tentative convergence outcome:
For operations within US taxing jurisdictions: to retain the current approach in
FAS 109.
For operations beyond US taxing jurisdictions: to require an approach that is
consistent with IFRS.
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Income Taxes Key Differences
and Short Term Convergence
Investments in
subsidiaries,
treatment of
undistributed profit
IFRS
US GAAP
Deferred tax liability
is recognised except
when the parent is
able to control and it
is probable that the
temporary difference
will not reverse
Deferred tax liability is required on
temporary differences arising after 1992
that relate to investments in domestic
subsidiaries, unless such amounts can be
recovered tax-free and the entity expects
to use that method. No deferred taxes are
recognised on undistributed profits of
foreign subsidiaries that meet the indefinite
reversal criterion.
Tentative convergence outcome:
The IASB tentatively decided to adopt the current FAS109 approach including the APB23
exception.
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Income Taxes Key Differences
and Short Term Convergence
IFRS
Intercompany
Transfers of Assets
US GAAP
Contains no
exception
Intercompany transfer of assets between
jurisdictions is a taxable event and
establishes a new tax base for those
assets.
Taxes must be paid by the seller on
intercompany profits.
Prohibits the establishment of a deferred
tax asset for basis differences.
Tentative convergence outcome:
FASB will amend FAS109 to eliminate this exception.
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Income Taxes Key Differences
and Short Term Convergence
IFRS
Foreign Nonmonetary Assets and
Liabilities
US GAAP
IAS 12 contains no
exception.
Prohibits recognition of a deferred tax
asset or liability for differences related to
assets and liabilities that, are
remeasured from the local currency into
the functional currency using historical
exchange rates and that result from (i)
changes in exchange rates or (ii)
indexing for tax purposes.
Tentative convergence outcome:
The FASB decided to amend SFAS 109 Para 9f to eliminate this exception
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Income Taxes Key Differences
and Short Term Convergence
IFRS
Distributed or
undistributed rate
US GAAP
In measuring deferred
tax assets and liabilities,
IAS 12 requires use of
the tax rate applicable to
undistributed profits.
US GAAP requires the use of the tax
rate applicable to distributed profits if
the tax rate applicable to distributed
profits is higher than the tax rate
applicable to undistributed profits.
Tentative convergence outcome:
The IASB decided that in jurisdictions that have a different tax rate depending on whether
taxable earnings are distributed to owners, an entity should use the rate(s) that it expects
will apply to the item being measured, incorporating the entity’s past practices and future
expectations of distributions. When determining future expectations of distributions, the
entity must have the intention and ability to make distributions for the foreseeable future.
The FASB is still to consider this proposal.
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Income Taxes Key Differences
and Short Term Convergence
IFRS
US GAAP
Uncertain Tax Positions - •IAS 12 is silent on the issue of
Guidance
uncertainty in the amounts
underlying current and deferred
tax.
•Recognize tax benefit when
it is more likely than not to be
sustained, measured as the
largest amount of benefit that
is greater than 50% likely of
being realized.
Uncertain Tax Positions - •Unit of account is individual tax
Recognition
position, OR
•The aggregate positions with a
taxing authority for a taxable
entity.
•Unit of account is the
individual tax position.
Uncertain Tax Positions - •Probability weighted average
Measurement
approach, OR
•Single best estimate/most likely
outcome
•Cumulative probability
methodology
Tentative convergence outcome: To be announced
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Income Taxes Key Differences
and Short Term Convergence
IFRS
US GAAP
Balance Sheet Disclosure
General guidance presented in IAS 12.5
focused upon income taxes including all
foreign and domestic taxes based on
taxable profits.
FIN 48 liability must be presented
separately from other income tax
liabilities.
Classification on Financial
Statements
Must be presented as a component of
current tax liability unless entity has an
unconditional right to defer payment for
more than 12 months.
Liabilities are classified as noncurrent unless a cash payment is
expected within the next 12
months.
Classification of Interest and
Penalties
When interest and penalties can be
identified and separated from related tax
liability, they must not be classified as
tax expense in the income statement.
They must be classified as finance costs
or other operating expenses.
Accounting policy election that
permits “above” or “below” the line
treatment.
Disclosure of Reserves
Not applicable
Substantial interim and annual
qualitative and quantitative
requirements.
Tentative convergence outcome: To be announced
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Current areas of divergence in the area of income taxes
Income Taxes Key Differences
and Short Term Convergence
Subsequent changes in
deferred taxes related to
items initially recorded
directly in equity
IFRS
US GAAP
Subsequent changes are
recognized directly in equity. (i.e.
full backward tracing with limited
exclusions)
Subsequent changes are
recognized in income,
with limited exceptions.
Tentative convergence outcome:
The IASB decided to amend IAS 12 to adopt the intraperiod allocation requirements of
SFAS 109. Subsequent changes in deferred taxes related to items initially recorded
directly in equity may under the intraperiod allocation rules be recognized in other Income
Statement categories e.g. continuing operations, discontinued operations or equity.
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Income Taxes Key Differences
and Short Term Convergence
IFRS
Difference between
book basis goodwill
and deductible tax
basis goodwill
IFRS does not allow for a DTL to be
recorded on a day one difference
between book basis goodwill and
deductible tax goodwill. A DTA may
however be recognized where tax
exceeds book.
US GAAP
No deferred taxes are
recognized for an excess
of tax basis goodwill over
book basis goodwill.
Tentative convergence outcome:
As part of the business combinations convergence project, it has been agreed that where
there is tax goodwill in excess of book goodwill on acquisition, deferred taxes will be
provided on the excess tax depreciation using a simultaneous equation methodology i.e.
record the deferred tax asset.
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Income Taxes Key Differences
and Short Term Convergence
IFRS
Business Combinations Measurement of non-controlling
interests using fair value or the
proportionate share of the acquiree’s
identifiable assets
US GAAP
Measurement of noncontrolling interests using
fair value
Tentative convergence outcome:
•Changes inside the measurement period will impact goodwill, then earnings – no reduction
to intangibles
•Changes outside the measurement period will impact earnings, not goodwill.
•Changes to valuation allowance will be recorded in income.
•Record deferred tax assets on excess tax-deductible goodwill
•Transaction costs are expensed as incurred.
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Income Taxes Key Differences
and Short Term Convergence
IFRS
Financial Statement
disclosure differences
US GAAP
•The effect of changes in tax rates or laws
substantively enacted after the balance sheet
date
•Not required
•No specific disclosures relating to
intercompany transfers of inventory
•No specific disclosures
relating to intercompany
transfers of inventory
•Reconciliation between tax expense and pretax accounting profit using aggregation of
separate reconciliations using individual
jurisdiction tax rates.
•Reconciliation between tax
expense and pre-tax
accounting profit using
statutory tax rate
Tentative convergence outcome:
•Disclosure of the effect of changes in tax rates after the balance sheet date is not required.
•Disclose the component of deferred tax assets and liabilities representing the effect of intercompany transfers
of assets between taxing jurisdictions with different effective tax rates.
•The IASB will amend IAS 12 to require the use of the statutory rate applicable to the parent company.
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Key Differences Between IFRS
and US GAAP
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Differences Between IFRS and US GAAP –
Hot Topics
•
Revenue Recognition
•
Inventory Reporting
•
Business Combinations
•
Components of Financial Statements
•
Taxes
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Inventory Reporting
IFRS
US GAAP
Costing Methods
LIFO is prohibited.
LIFO is an acceptable
method.
Measurement
Inventory is carried at
the lower of cost or net
realizable value.
Inventory is carried at
the lower of cost or
market.
Reversal of Inventory
Write Downs
Previously recognized
impairment losses are
reversed, up to the
amount of the original
loss.
Any write downs of
inventory cannot be
reversed.
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Accounting for Income Taxes
IFRS Conversion Focuses on:
•
•
•
•
•
Effective tax rate
Cash tax
International taxation
State taxation
Processes and controls
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Tax Considerations of IFRS
• Effective tax rate considerations
– Differences in pre tax income under IFRS
– Income tax uncertainties
• Cash tax considerations
– LIFO
– Tax accounting methods
• Other considerations
– Transfer pricing documentation
– Share based payments and other compensation
matters
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Tax Considerations of IFRS
• State and Local Taxation
• Systems, Processes, and Controls
• International Tax Considerations
– Tax Planning
– Measurement Concepts
– Financial Statement Impact
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Questions and Answers
<Datum>
2008
OFII Tax Conference
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