It’s entirely normal for businesses to seek to reduce their tax burdens and either minimize or defer cash outflows for income taxes.

This causes most business tax returns to include tax postures which may be subject to significant and varied interpretations—from domestic and foreign income allocations arrangements to transfer pricing between affiliates and others. Tax filing postures often result in uncertainties about whether the postures will ultimately pass the review of the relevant taxing authorities. This could occur several years after filing the returns.

In July 2006, the Financial Accounting Standards Board (FASB) released FASB Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes.” Its goal was to reduce the substantial diversity in accounting for tax uncertainties that developed as both public and private companies evaluate, for financial reporting purposes, the likelihood that the benefits of tax postures will be sustained. These varied interpretations came about because FASB Statement No. 109, “Accounting for Income Taxes,” contains no specific guidance on how to address uncertainty in accounting for income tax assets and liabilities. The key concern is the proper presentation of these income tax assets and liabilities for financial statement purposes. FIN 48 generally applies to all U.S. federal, state and local income tax positions and foreign tax positions.

Key Points in FIN 48

• A tax benefit may only be reflected in the financial statements if it is “more likely than not” (more than 50 percent likelihood) that the company will be able to sustain the tax return position upon examination, based on its technical merits and assuming full disclosure of the facts. The “more likely than not” test is a substantially greater hurdle than the former “reasonableness” test.
• A tax benefit should be measured as the largest amount of benefit that is cumulatively greater than 50 percent likely to be realized.
• Additional disclosures—including positions expected by management to change significantly within the next 12 months—as well as the quantitative roll forward of the worldwide aggregated amount of unrecognized tax benefits.
• Tax positions must be evaluated at each balance sheet date.

In January 2007, the FASB confirmed the implementation date of FIN 48 for accounting periods starting after December 15, 2006 (e.g., January 1, 2007, for calendar year entities). Most SEC companies implemented FIN 48 standards throughout their 2007 reporting cycle. Just prior to reporting season for privately-held companies, the FASB met and extended the date of application for non-public companies to periods starting after December 15, 2007. For many businesses, particularly those with an international parent or international subsidiaries, this development has both far-reaching implications and a small window of time for implementation for businesses affected by this ruling to ensure that their financial statements reflect expected past and future tax consequences of uncertain tax positions. This interpretation applies to all entities that report in accordance with GAAP, including public and private companies, not-for-profit organizations, pass-through entities (such as partnerships) and certain real estate investment structures. To avoid a penalty, it requires a higher standard of tax benefit accruing in financial statements than the IRS imposes on tax returns.

For tax years beginning after December 15, 2006 (and now December 15, 2007), the tax accrual may only contain positions meeting the “more-likely-than-not” standard. Variances must be disclosed in the financial statements. This creates more work for the auditor on the tax accrual because even common issues like unreasonable compensation or expensing versus capitalization now need to be evaluated. The positions taken on the return (or that were taken in any year not closed by the statute of limitations) that don’t meet the “more-likely-than-not” standard will have to be disclosed and will likely be subject to increased IRS scrutiny.

For many entities, their most uncertain tax positions may be in relation to their transfer pricing policies. For companies with material related party transactions, the external auditor will have to pay heavy attention to each company’s transfer pricing study.

With calendar-year corporations, the new rules would initially take effect with 2007’s first-quarter results. However, the new rules require these corporations to have a “clean” starting point for their tax returns as of January 1, 2007. The deferred tax asset and deferred tax liability accounts on that date must be determined in accordance with the standards of FIN 48. IBI