Accounting Methods & Periods
FIN 48 Compliance: Disclosing Tax Positions in an Age of Uncertainty
1 Additional guidance on the GAAP for income taxes is found in Accounting Principles Board (APB) Standards No. 23, Accounting for Income Taxes, Special Areas, and No. 28, Accounting for Income Taxes in Interim Periods.
2 On November 15, 2007, the FASB voted to delay the effective date for all nonpublic entities to periods beginning after December 15, 2007.
3 “This Interpretation will result in increased relevance and comparability in financial reporting of income taxes.... the disclosure provisions of this Interpretation will provide more information about the uncertainty in income tax assets and liabilities.” FIN 48, Summary, p. 4.
4 Evidence of large-scale disparity between book and tax income was identified in corporate failures such as Enron. McGill and Outslay, “Did Enron Pay Taxes? Using Accounting Information to Decipher Tax Status,” 19 Tax Notes (August 19, 2002): 1125–36.
5 Generally, the effective tax rate is computed separately for the taxpayer’s federal, state/local, and international operations, as income tax expense/pretax book income. Earnings management in the tax accrual for income taxes has been well documented. Based on a random sample of 100 Fortune 500 firms, an increase in earnings per share of $.09 was found from reversal of the tax cushion in 2003–2005 quarterly earnings reports; see Gupta and Laurx, “Do Firms Use Tax Cushion Reversals to Meet Earnings Targets?” Paper presented at the annual meeting of the American Accounting Association, Chicago, August 7, 2007. Material accruals for tax contingencies by large firms were likely used for earnings management; see Gleason and Mills, “Materiality and Contingent Tax Liability Reporting,” 77 Acct. Rev. (2002): 317–42. Firm changes in effective tax rates from the third to the fourth quarter suggest the use of tax cushions in earnings management; see Dahaliwahl, Gleason, and Mills, “Last Chance Earnings Management: Using the Tax Expense to Meet Analysts’ Forecasts,” 21 Contemp. Acct. Res. (2004): 431–59.
6 Schedule M-3 filers include corporations and passthrough entities with gross assets of $10 million or more. Additional asset, income, and ownership tests also apply to partnerships; see Everett, Hennig, and Raabe, A Practical Guide to Schedule M-3 Compliance (CCH, 2008). When the Schedule M-3 reporting requirements are fully in place, perhaps as many as 250,000 annual tax returns will include the schedule.
7 However, the IRS has sought tax accrual workpapers relating to “listed transactions” for abusive tax shelter activities, most recently in Textron, Inc. (D. R.I. 8/28/07). Donald Korb, chief counsel for the IRS, indicated that documents produced by a taxpayer or its auditors to comply with FIN 48 are considered tax accrual workpapers, stating that the IRS is “not going to turn a blind eye” to the FIN 48 tax reserve details (Leone, “FIN 48: Standing Naked Before the IRS” (5/22/07), www.cfo.com/article.cfm/9216349). See also the chief counsel memorandum from Korb to Deborah Nolan, “FIN 48 and Tax Accrual Workpapers,” AM 2007-0012 (6/8/07).
8 Field Examiners’ Guide LMSB-04-0507-045, FIN 48 Implications (May 2007), www.irs.gov/businesses/corporations/article/0,,id=171859,00.html, and LMSB Commissioner Memorandum LMSB-04-0507-044, FIN 48 and Tax Accrual Workpaper (TAW) Policy Update (5/10/07). See also “Key Issues in Tax Policy: A 2007 Tax Analysts Conference on Financial Reporting and Corporate Transparency,” 2007 TNT 144-39, Doc. 2007-17299, p. 21 (July 13, 2007).
9 Chief Counsel Notice 2007-015 (6/20/07). Robin Greenhouse of McDermott Will & Emery disagrees. “Effective tax rate reconciliation workpapers, whether created by the taxpayer or the auditor, are part of the tax accrual workpapers” and are thus subject to restraint. Coder, “IRS Position on Definition of Tax Accrual Workpapers Generates Skepticism,” 2007 TNT 137-3, Doc. 2007-16617, p. 2 (July 17, 2007).
10Drucker, “Why Firms’ Tax Cuts Get Senate’s Attention,” Wall Street Journal, September 11, 2007, p. A3. The full text of the letter is available at 2007 TNT 170-24, Doc. 2007-20090 (August 23, 2007).
11 See Nichols, Briggs, and Baril, “And the Impact Is . . . First-Quarter Results from Adopting FIN 48,” 2007 TNT 147-39, Doc. 2007-16167 (July 31, 2007), for an analysis of the 2007 first-quarter disclosures.
12 Leone, “FIN 48: Standing Naked Before the IRS” (5/22/07), www.cfo.com/article.cfm/9216349. Tammy Whitehouse argues that “such disclosures would provide the IRS with a roadmap for auditing the tax return and weaken taxpayers’ ability to defend their tax positions” (Whitehouse, “Oh, Joy: IRS Eager for FIN 48 Data” (8/7/07)). However, a recently issued IRS Large and Mid-Size Business (LMSB) Division Field Examiners’ Guide indicated that the disclosures should not be viewed as a road map because they do not have the specificity that would allow a perfect view of the issues and amounts at risk (Field Examiners’ Guide LMSB-04-0507-045, FIN 48 Implications (May 2007)).
13 FAS 109 ¶21 lists four possible income sources that may be available under the tax law to realize such a tax benefit: (1) future reversals of existing taxable temporary differences, (2) future taxable income exclusive of reversing temporary differences and carryforwards, (3) taxable income in prior carryback year(s) if a carryback is permitted under the Code, and (4) tax planning strategies implemented to accelerate taxable income amounts, change the character of taxable or deductible amounts, or switch from tax-exempt to taxable investments.
14 Early drafts of FIN 48 used the “probable” standard, but public response led to the adoption of the “more likely than not” (MLTN) test.
15 FIN 48 ¶4 states that a tax position also encompasses but is not limited to (1) a decision to file a tax return, (2) an allocation or shift of income between jurisdictions, (3) the characterization of income or a decision to exclude reporting taxable income in a tax return, or (4) a decision to classify a transaction, entity, or other position in a tax return as tax exempt.
16 FASB Staff Position, FSP FIN 48-1, posted May 2, 2007, changed the original wording of FIN 48 from “tax matter is ultimately settled” to “tax position is effectively settled.” See also Brazzil and Stein, “FIN 48 and IRS Settlements,” 2007 TNT 167-39, Doc. 2007-18264 (August 28, 2007).
17 FIN 48 ¶5.
18 If the statute of limitation for the relevant authority to examine and challenge a previously unrecognized tax position has expired, the tax benefit will then be recognized in the financial statements.
19 Regs. Sec. 1.6662-4(d). The MLTN standard is also applied in assessing the Sec. 6694(a) tax preparer penalty, which is the greater of $1,000 or 50% of the income derived (or to be derived) by the tax return preparer.
20 Sec. 6694(a)(2) requires that a position would more likely than not be sustained on its merits or it must be adequately disclosed on the tax return to avoid a tax preparer penalty. Taxpayers may be required “to provide more documentation to support aggressive tax positions and [this] may result in increased tax preparation fees to cover more research on complex tax rules” (Herman, “The IRS Has a New Weapon,” Wall Street Journal, July 11, 2007, p. D1). “To the extent that the likelihood of the tax position being sustained would fall between the realistic possibility standard and the more-likely-than-not threshold, a company would no longer recognize the benefits of the tax position in its financial statements. This could adversely affect debt ratios, increase interest expense, and increase a company’s effective tax rate” (Jones and Campbell, “Financial-Reporting Effects of Uncertain Tax Positions,” CPA Journal (March 2007): 2).
21 Blouin, Gleason, Mills, and Sikes, “Do Firms Eat Their Cookies Before FIN 48 Reveals the Cookie Jar?” Paper presented at the annual meeting of the American Accounting Association, Chicago, August 7, 2007.
22 This will be broken down into its current and noncurrent components later.
23 In FIN 48, Appendix B, ¶B12, the FASB noted: “The Board concluded that limiting the application to only uncertain tax positions, or tax positions with specified attributes, would create a rules-based standard that would result in inconsistent application and would add complexity to the accounting guidance for income taxes.”
24 FASB Statement of Financial Accounting Concepts No. 7, Using Cash Flow Information and Present Value in Accounting Measurements. FIN 48, Appendix B, ¶B26, indicates that an expected-outcome measurement would be conceptually superior when uncertainty exists because that measurement would require consideration of all potential outcomes.
25 See Kimmelfield, “Measuring Tax Benefits in the Real World,” 2006 TNT 210-26, Doc. 2006-21304 (October 30, 2006). The author argues that the standard could be met by evaluating the MLTN chance of settlement by an appellate conferee or from litigation and then selecting the FIN 48 adjustment to make, depending on whether the company is willing to litigate the issue.
26 FIN 48, Appendix A, ¶¶A19 and A20.
27 FIN 48, Appendix A, ¶A20.
28 If indeed the Schedule M-3 can be viewed as a “road map” to the IRS for book-tax differences, it is important to reconcile the temporary differences disclosed on the Schedule M-3 with those included in the tax accrual workpapers.
29 FIN 48 ¶15.
30 Jones and Campbell, “Financial-Reporting Effects of Uncertain Tax Positions,” CPA Journal (March 2007): 4.
31 FIN 48 ¶19.
32 FIN 48 ¶16. “If a tax position does not meet the minimum statutory threshold to avoid payment of penalties, an enterprise shall recognize an expense for the amount of the statutory penalty in the period in which the enterprise claims or expects to claim the position in the tax return.”
33 Based on comments made by Judith McNamara, IRS Senior Program Analyst, at EEI Schedule M-3 seminar, Chicago, June 15, 2007.
34Assuming there is no true-up adjustment, lines 1 and 2 of Schedule M-3, part III, represent the current U.S. financial income tax expense of $2,321,860 and the U.S. deferred income tax expense of –$72,505 (–$74,800 + $2,295) for a total of $2,249,355.
35For a discussion of the adequacy of FIN 48 footnote disclosures, see Nichols, Baril, and Briggs, “Early Indications of the Impact of FIN 48,” 2007 TNT 132-21, Doc. 2007-15070 (June 22, 2007).
36 FIN 48 ¶12.
37 Throndson and Urban, “Thinking Beyond Uncertain Tax Positions: Understanding the Potential Impact of Interest Computations and Penalties,” PricewaterhouseCoopers LLP, February 1, 2007, available at www.tinyurl.com/368jcl.
38 Robert D. Adams, senior advisor to Deborah Nolan, LMSB Division Commissioner, in remarks to the District of Columbia Bar Taxation Section (February 8, 2007). Nolan announced that the IRS was reevaluating its accrual workpaper policy in a speech at a District of Columbia Bar Taxation Section forum (April 12, 2007).
39 Kathryn A. Zuba, IRS special counsel with the associate chief counsel for procedure and administration, quoted at 2007 TNT 48-6 (March 12, 2007).
40 Dita Tonuzi, IRS Office of the Chief Counsel, quoted at 2007 TNT 48-6 (March 12, 2007).
