FIN 48 Compliance: Disclosing Tax Positions in an Age of Uncertainty

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EXECUTIVE SUMMARY

• The interaction of FAS 109 and FIN 48 will result in greater public disclosure of tax planning techniques.

• Under FIN 48, a tax position is recorded only if the tax position is more likely than not to be sustained on examination (including related appeals or litigation processes).

• A material tax position is tested under a two-step process consisting of a recognition step and a measurement step.

• FIN 48 requires a reevaluation of all tax positions at the end of each reporting period. Prior recognized positions may be derecognized or remeasured, and prior unrecognized positions may be recognized in each reevaluation.

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For financial statements prepared under U.S. generally accepted accounting principles (GAAP), the tax effects of the entity’s operations have been governed by Statement of Financial Accounting Standards (FAS) No. 5, Accounting for Contingencies, and FAS No. 109, Accounting for Income Taxes. ¹ Financial Accounting Standards Board (FASB) Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, a new interpretation of FAS No. 109 and APB No. 28 issued in July 2006, is effective for accounting years beginning after December 15, 2006.² This interpretation presents new challenges for taxpayers, auditors, and tax advisers. The disclosures required by the interaction of FAS 109 and FIN 48 will result in greater public disclosure of tax planning techniques, including the strengths and weaknesses of those techniques.³

FIN 48 is a response to the perceived public desire for greater transparency of financial data and is in part a result of the abusive tax-shelter activities of the 1990s and the financial accounting scandals of the early 2000s.⁴ Questions arose regarding potential manipulation of reported earnings, including managing the effective tax rate reported in financial statements.⁵ Furthermore, a large number of the material weaknesses and significant deficiencies initially reported under Sarbanes-Oxley were traceable to the construct of the entity’s income tax expense. In the tax realm, regulatory responses to the perceived desire for greater financial transparency led to new Schedule M-3 reporting requirements for corporations and passthrough entities,⁶ which require book-tax differences to be disclosed in two columns, one for temporary differences and one for permanent differences. Items disclosed in the temporary column should agree with items used to compute deferred tax assets and liabilities under FAS 109, while permanent differences should agree with items used to compute the effective tax rate.

Implementation of FIN 48 “lifts the veil” regarding tax strategies to an extent that may not be appropriate or healthy in the context of an adversarial, voluntary-compliance tax system.

Tax Strategies

Current tax planning strategies include:

• Establishing a set of financial goals;
• Developing a tax strategy as part of overall financial goals;
• Planning and executing a series of transactions aimed at managing tax liability;
• Reporting the results of the transactions on financial statements and tax returns;
• Separately subjecting these reports to review by financial and tax auditors;
• Justifying tax positions and, when necessary, revising financial reporting if required through SEC restatements; and
• Adjusting the tax liability after settlement of a tax issue through negotiation and (perhaps) litigation.

Final resolution of a transaction’s appropriate accounting and tax reporting does not occur until long after the financial statements and tax returns have been prepared. In addition, the tax expense reported in the financial statements and the tax return may differ, requiring “true-up” adjustments after the tax return is filed. An entity cannot be certain as to the final reporting of certain transactions until an IRS audit is completed and any necessary adjustments are made. Thus, decisions regarding computation of the financial tax expense necessarily require the exercise of professional judgment regarding:

• Whether a tax return must be filed in various jurisdictions;
• How to claim and compute various income, deduction, and credit items;
• Whether the entity’s status as an S corporation, controlled foreign corporation, or exempt organization has been maintained during the reporting year; and
• Whether IRS personnel and the courts will take exception to the taxpayer’s tax return positions.

The financial accounting expense for income and other taxes can be both sizable and material on the financial statements and is likely one of the last accruals made when computing net income for the period. Before FIN 48 was issued, a taxpayer’s required disclosure of the tax expense computation for the year was limited to a series of footnote discussions on the choice of tax accounting methods, policies, and various effective tax rates for the reporting year. The tax footnote discussed current year settlements of tax audits, anticipated results of ongoing audits, and the potential expiration of any net operating loss (NOL), capital loss, and tax credit carryforwards.

The IRS could subpoena the entity’s tax accrual workpapers, which likely include a listing of and computational projections for tax minimization techniques considered and applied in the tax year, as well as computational assumptions and conventions used to determine the current and deferred tax expense. In a welcome spirit of “playing fair” with its adversary the taxpayer, the IRS has shown restraint in obtaining tax accrual workpapers by rarely using its subpoena power.⁷ The IRS recently announced that documents produced by a taxpayer or its auditors to substantiate the taxpayer’s uncertain tax position in compliance with FIN 48 are considered tax accrual workpapers and will be subject to its current policy of restraint.⁸ However, the IRS chief counsel reached the opposite conclusion regarding effective tax rate reconciliation workpapers because permanent timing differences between the statutory tax rate and the effective tax rate must be reported in the Schedule M-3.⁹

The Senate’s Permanent Subcommittee on Investigations, chaired by Senator Carl Levin, sent a letter to at least 30 companies, asking for details on unrecognized tax benefits reported under FIN 48, as part of its investigation into corporate tax-cutting transactions.¹⁰

The application of FIN 48 greatly extends the amount and type of public disclosures by GAAP taxpayers.¹¹ This may affect the likelihood that a tax position will be challenged in an IRS audit, especially if additional disclosures reveal the strengths and weaknesses of positions taken on the tax return.¹² It is not an exaggeration to state that the scope of FIN 48’s effects on the financial reporting and tax communities is the most extensive in memory.

FIN 48 Disclosures

When a taxpayer applies an exclusion, exemption, or credit to an item included in financial accounting income, FAS 109 accounts for the current tax reduction as a permanent difference from book income, which reduces the entity’s effective income tax rate reported in the financial statement footnotes. Permanent differences affect the computation and disclosure of the current federal, state/local, and international effective tax rates. Temporary differences give rise to either a deferred tax liability or a deferred tax asset. When a deduction is accelerated or income is deferred from that allowed for financial accounting purposes, a deferred tax liability is created and reported on the balance sheet. When a deduction is deferred or income is accelerated from that recorded in the books, a deferred tax asset is created.

For every accounting year, the financial statements record changes in the entity’s deferred tax assets or liabilities that are traceable to temporary differences between book and taxable income. Using FAS 109 terminology, the taxpayer likely prefers to create permanent tax differences so as to reduce the effective tax rate for the period and uses temporary differences to create and increase the deferred tax liability, because tax reductions improve the entity’s cashflow for the current reporting period.

Legitimate tax planning strategies include taking one or more tax return positions with which the IRS might disagree, potentially resulting in an audit adjustment and settlement through the appeals process or litigation. Entity tax departments and their tax advisers work to manage the tax liability in this way, taking supportable but taxpayer-friendly return positions and managing the risk of taking such positions in an appropriate manner. For financial accounting purposes, though, how does one account for these tax uncertainties? Should the tax return position be assumed to be fully correct such that the effective tax rate is reduced or the deferred tax benefit is recorded in full in the current financial reporting period?

The basic rule of FAS 109 assumes that deferred tax benefits eventually will be fully realized.¹³ For those items with some uncertainty as to their future realization, a valuation allowance is used to “write down” the deferred tax asset to an amount that more likely than not will be realized. Creation and maintenance of the valuation allowance entails the use of professional judgment by the tax adviser and the financial accountant to forecast the book and tax flow of future income and expense over time. To prepare for a possible audit of the valuation allowance, the entity must document the assumptions and decisions used. Before applying a valuation allowance analysis, FIN 48 requires the taxpayer first to assess the likelihood that its tax position will be sustained on review by the tax authorities. After making this determination, a valuation allowance may be recorded to address the realizability of the tax benefits with further computations and disclosures required in the financial statements to indicate the effects of the tax positions taken.

For example, in the case of a NOL carryforward, if there are no uncertain tax positions regarding its computation, under FAS 109 a forecast of future revenues is made to determine if sufficient taxable income will be generated to absorb the carryforward. Likewise, even if there are no uncertain tax positions regarding the computation of a foreign tax credit carryforward, a projection of future foreign-source income must be made to project whether the credit actually will be used on future tax returns. The FIN 48 process is used to ensure that a tax-related asset or liability actually exists at the date the financial statements are prepared and that the tax position will be sustained on review by the tax authorities.

Before FIN 48, FAS 5 stated that a contingent tax liability was reported in the financial statements if the future event or events on which the contingency was based were “probable” (i.e., likely to occur). Most observers believed that the probable standard required a 75% or higher probability of occurrence for an item to be recorded in the financial statements.¹⁴ The new FIN 48 requirements override many of the FAS 5 rules. The most critical of the FIN 48 requirements is the required disclosure of material financial statement effects attributable to positions taken on federal, state/local, and international income tax returns for both permanent and temporary differences between book and taxable income. A deferred tax asset or liability is recorded only if the tax position is more likely than not to be sustained on examination (including the resolution of related appeals or litigation processes). This represents a refinement and extension of the existing FAS 109 rules.

When FIN 48 applies, “uncertain” tax positions are defined as those material items not fully certain by the taxpayer to be sustainable on a later review based on their technical merits. A tax position is defined as a position on a previously filed tax return or a position expected to be taken in a future tax return that is reflected in measuring current or deferred income tax assets and liabilities for interim or annual periods. A tax position can result in a permanent reduction of income taxes payable, a deferral of income taxes otherwise currently payable to future years, or a change in the expected realizability of a deferred tax asset.¹⁵ Under FIN 48, a tax benefit is included in the financial statements when:

• It is determined that it is more likely than not that a tax return position resulting in the benefit can be sustained on its technical merits, or
• A tax benefit or liability has been effectively settled by the completion of an audit, a negotiated settlement, or the issuance of a court decision.¹⁶

The appropriate unit of account for a tax position is a matter of judgment and requires consideration of how the enterprise prepares its income tax return and the approach that the enterprise anticipates the taxing authority will take during an examination.¹⁷

When FIN 48 applies, the taxpayer must disclose each of the following:

• The total unrecognized tax benefits measured at both the beginning and the end of the reporting year. The ending balance then “rolls forward” and becomes the beginning balance for the subsequent year.
• A projection in some detail regarding how the unrecognized tax benefits are expected to change over the next 12 months, including the nature of each of the uncertain tax positions, estimated dollar amounts, and the conditions under which a change in the tax benefits would occur.
• The impact on the effective tax rate of disclosed unrealized tax benefits.
• A listing of any “open” tax years under applicable statutes of limitation and by major taxing jurisdictions.
• A description of the financial accounting policies on the treatment of applicable accrued interest and penalties and their amounts.

Recognition and Measurement

For every material tax position that relates to the current financial statements, the taxpayer must answer the following questions:

The recognition step: Is it more likely than not (a greater than 50% probability) that the position would be sustained on its technical merits after a review by the tax authorities, including the appeal process?¹⁸ The MLTN standard is a lower threshold than the probable standard of FAS 5 but is higher than the substantial authority test required for disclosing a tax position taken on a tax return.¹⁹

The measurement step: If so, what is the largest tax benefit that the taxpayer more likely than not will realize as a result of that review?

Both the recognition step and the measurement step must be applied to each uncertain tax position. A position that meets the MLTN threshold is initially and subsequently measured as the largest amount of tax benefit that is more likely than not to be realized on settlement with a taxing authority that has full knowledge of all relevant information.

No determination is to be made by the taxpayer as to the likelihood of an audit per se; the taxpayer should act as though the uncertain position will be audited by the appropriate taxing authority. The MLTN standard entails a presumed lack or rejection of the return position were the item reviewed by the highest level of judicial review in the appropriate jurisdiction. It also presumes that all members of the tax community, including government personnel, possess high-level skills in tax research and analysis. Such skills include the ability to find pertinent law and resolve differences when various tax law sources are in conflict.

Because a high-level judicial review of the tax law is a rare occurrence, the most sophisticated types of professional judgment are required to make legal evaluations of this sort. Injecting assessments such as these into the process of financial statement disclosure and into the initial decisions on how to construct a transaction and report it on the tax return brings inordinate complexity to the annual tax compliance and financial accounting cycle.²⁰ In effect, broad-based estimates of future tax benefits and establishment of tax-payment “cushions” are things of the past under FIN 48.²¹

Mechanically, an application of the measurement process can be depicted in the following procedure suggested (but not required) by FIN 48. A comparable analysis must be made for every FIN 48 uncertain tax position.

Example: Assume that a NOL carryforward has a deferred tax benefit of $100. Based on the probability distribution derived by tax and accounting professionals (Exhibit 1), the financial statements would reflect a $40 deferred tax asset. It is more likely than not that a tax benefit of at least that amount would be realized on settlement because the cumulative probability first exceeds 50% at the point of the $40 outcome (in this case, an 85% cumulative probability).

The financial accounting disclosure of an uncertain tax position is made in the first annual or interim report for which the MLTN threshold is met and must be reevaluated in each reporting period, taking into account tax law, settlement, and attitudinal changes occurring throughout the reporting period. Changes in the probability assessments also should reflect changes in the taxpayer’s filing status, carryover amounts, and expiration of statutes of limitation. Substantive changes are reflected by revising projected outcomes of the uncertain items and the likelihood of their being sustained after a technical review, not by changes to valuation allowances.

Continuing with the example:

• The issuance of a court case unfavorable to the taxpayer’s position might reduce the anticipated reported benefit to $0.
• Adoption of a more favorable attitude of negotiating settlements by the IRS might permit an increase in the probabilities of the $60 and $100 outcomes, thereby permitting restoration of the deferred tax asset to its original amount.

Computing Tax Expense and Liability Before FIN 48

A detailed discussion of the tax accrual both pre- and post-FIN 48 is based on the facts in the case study in Exhibit 2 (p. 28).

Before the release of FIN 48, Quasar Company would have applied the principles of FAS 109 in computing its financial income tax expense and tax payable. It would have applied FAS 5 to the three uncertain tax positions, items 5, 7, and 8. As explained below, item 6, the capital loss, is not an uncertain tax position but does require a valuation allowance because of the uncertainty of being able to use the loss within the carryforward period.

In applying FAS 5 to its uncertain tax positions, the firm likely would have carved out as contingent liabilities only those aggressive tax positions involving material audit risk. Such a tax cushion provided for the possibility of IRS disallowance of the items in question. Because FAS 109 offered little guidance as to which tax effects of its positions should be recognized in financial statements and in what amounts, most companies simply assumed that the current and projected tax filings could be taken at face value by reporting 100% of the tax benefits. If it is probable that the tax positions are sustainable on audit, there is no accrual for a contingent tax liability under FAS 5. For this example, the FAS 109 process will be separated into two steps. In step 1, book-tax differences and the financial tax expense are computed (Exhibit 3).

In step 2, Quasar records a valuation allowance. After considering all available evidence, Quasar concludes it is more likely than not that the expected value of the capital loss carryforward is only $8,250 (55% of the total available carryforward) due to the uncertainty of projected future capital gain income. Thus, a valuation account of $2,295 must be created ($15,000 × .45 × .34), which in turn increases the net financial tax expense.

Combining these two steps, the net financial tax expense is $2,176,255 ($2,173,960 + $2,295). The journal entry to record the tax accrual is in Exhibit 4, above.²²

Computing Tax Expense and Liability Under FIN 48

The FIN 48 two-step process, applicable for tax years ending after December 15, 2006, is best illustrated by revisiting the facts of the case study (Exhibit 2, p. 28). Note that FIN 48 applies to all tax positions, not just a subset of positions called uncertain tax positions.²³ The case study assumes no prior-year tax accruals or open tax positions. Otherwise the cumulative effect of applying FIN 48 to those items would be reported as an adjustment to the opening balance of retained earnings. It is assumed that management documents its determination that the MLTN test is met by computing the expected value of the tax position’s probable tax outcomes. Although not specifically required by FIN 48, an expected-value approach considers all probable outcomes and is consistent with other financial accounting rules.²⁴

It is important to note that the expected-value approach illustrated in applying the case study’s MLTN test is not required under FIN 48. In performing this test, FIN 48 clearly states that it is a matter of judgment and that the enterprise should consider the facts, circumstances, and information available at the reporting date. The largest tax benefit that is more likely than not to be realized on ultimate settlement with the taxing authority could be determined by taking into account the company’s willingness to settle the issue at various levels.²⁵ The case study’s expected-value computation is simply a tool that may assist the enterprise in making that judgment.

Applying FIN 48’s Two-Step Process to Highly Certain Tax Positions

FIN 48 offers illustrative guidance for addressing the issue of a highly certain tax position on a potential deduction, i.e., where a taxpayer believes that a tax position is based on clear and unambiguous tax law and the amount is therefore clearly deductible.²⁶ In such a case, the taxpayer could “recognize the full amount of the tax position in the financial statements.”²⁷ This statement has been interpreted as implying that highly certain tax positions use an application recognition matrix and a measurement matrix with only two possible outcomes: a 0% chance of $0 deducted and a 100% chance of the full amount being deducted. See Exhibit 5 for the matrix for the $60,000 domestic production activities deduction under Sec. 199.

The recognition test indicates that the tax position meets the MLTN standard, so the position is recognized. The measurement test indicates that the benefit of the tax position is $20,400 ($60,000 × 34%), the first potential outcome in the measurement matrix where the cumulative probability exceeds 50%. A similar analysis is applied to Quasar’s other highly certain tax positions, namely, the $5,000 bad debt expense, the $6,000 meals and entertainment expense, and the $15,000 capital loss. These transactions are reported on Schedule M-3, part II, lines 23a, 23c, and 24, and part III, lines 11, 22, and 32 (see appendices A and B).²⁸ Note that the capital loss and bad debt deductions are temporary differences reported in column (b), while the meal and entertainment deduction and domestic production activities deduction are permanent differences reported in column (c).

Applying FIN 48’s Two-Step Process to Uncertain Tax Positions

The two-step process as applied to each of the uncertain tax positions is examined separately, with different probability distributions for each item.

Partnership loss—Transaction 5: The tax position on the partnership loss qualifies for recognition because it is more likely than not that the position will be realized on settlement with a taxing authority. Based on the technical merits of the issue, management developed a probability distribution of possible outcomes (see Exhibit 6, p. 30). While not required by FIN 48, the 61% expected-value probability supports management’s assertion that the MLTN test has been met based on its technical merits.

Under FIN 48, the maximum tax benefit is $20,400, the first amount of benefit having a greater-than-50% likelihood of being realized (where the cumulative probability first exceeds 50%). Thus, a FIN 48 adjustment equal to the uncertain tax benefit is made. This in turn will have interest implications for subsequent reporting periods, as explained below. The partnership loss is reported on Schedule M-3, part II, line 9 (see appendix A).

Settlement of lawsuit—Transaction 7: Accruals for a judgment as a result of litigation under appeal are not currently deductible under the economic performance test of Sec. 461(h), which essentially places the taxpayer on the cash method for that item. Under the all-events test, an expense is recorded in the financial statements in the year in which the amount is fixed and determinable, creating a deferred tax benefit. If the lawsuit were deemed to be without merit, no accrual would be made, and a brief discussion of the suit would appear in the footnotes to the financial statements. If management determines that it is appropriate to accrue a book expense, FIN 48 applies because this is a tax position that will be taken on a tax return, once the suit is settled. Based on the issue’s technical merits, management developed a probability distribution of possible outcomes of the deductibility of the amount once it is paid (see Exhibit 7).

The tax position on the future deductibility of the payment when the lawsuit is settled qualifies for recognition because it is more likely than not that the position will be sustained on audit. The expected value of 52% can be used to document management’s assertion that the MLTN threshold has been met. Under FIN 48, the maximum tax benefit is $85,000, the first amount of benefit that has a greater-than-50% likelihood of being realized. Thus, the future tax benefit of $85,000 ($170,000 – $85,000) is not reflected in the tax accrual. This in turn will have interest implications for future reporting periods, as explained below. The deduction for resolution of the lawsuit is reported on Schedule M-3, part II, line 25 as a temporary difference (see appendix A).

Component depreciation deduction—Transaction 8: In evaluating the tax position on the $100,000 book-tax difference for the component depreciation deduction, management developed a probability distribution of possible outcomes based on the issue’s technical merits (see Exhibit 8).

The tax position concerning the component depreciation deduction qualifies for recognition because the MLTN test is met. Under FIN 48, the maximum tax benefit is $8,500, the first amount of benefit that has a greater-than-50% likelihood of being realized (where the cumulative probability exceeds 50%). Thus, the tax benefit of $25,500 ($34,000 – $8,500) should not be reflected in the tax accrual. This in turn will have interest implications for future reporting periods, as explained below. The depreciation deduction is reported on Schedule M-3, part III, line 31 as a temporary difference (see appendix B ).

Accounting for Interest and Penalties Under FIN 48

FIN 48 requires recognition of interest expense in the first period interest would begin accruing according to provisions of the relevant tax law:

The amount of interest expense to be recognized shall be computed by applying the applicable statutory rate of interest to the difference between the tax position recognized in accordance with this Interpretation and the amount previously taken or expected to be taken in a tax return.²⁹

The interest accrual is based on the current interest rate and the estimated intervening time interval until the uncertainty of the tax position is resolved:

FIN 48 requires a company to accrue interest and penalties when there is underpayment of taxes, based on management’s best estimate of the amount ultimately to be paid (not considering detection risk) in the same period that 1) the interest would begin accruing or 2) the penalties would first be assessed. The classification of interest (as interest expense or part of the income tax line item) and penalties (as part of the income tax line item or another expense classification) is an accounting policy election that should be consistently applied.³⁰

Since this is the first year in which Quasar’s uncertain tax positions were identified, no interest is accrued. However, in each reporting period after an uncertain tax position is taken on the tax return, interest must be accrued at the appropriate rate for that reporting period. Since the partnership loss and the component depreciation deduction were taken on the 2007 tax return, interest on these uncertain tax positions would be accrued starting in the first reporting period after the due date of the 2007 tax return. Since the lawsuit’s settlement will not be deducted until payment is made (three to five years in the future), interest would accrue only after the first reporting period the tax return is due in which the deduction is taken on the tax return. The FASB provides some flexibility in the reporting of the accrued interest:

Interest recognized in accordance with paragraph 15 of this Interpretation may be classified in the financial statements as either income taxes or interest expense, based on the accounting policy election of the taxpayer.³¹

When making this recommendation, the FASB did not consider the impact on Schedule M-3. Specifically, interest expense of this type generally represents a timing difference; categorizing the amount as tax expense would entail reporting the expenditure on Schedule M-3, part III, line 2, as a permanent difference.

FIN 48 also permits as part of the tax expense any statutory penalties that would apply if the tax position did not meet the minimum statutory threshold for avoiding payment of such penalty. As a practical matter, though, it is somewhat doubtful that this situation would occur for many positions that have met the MLTN threshold unless the understatement of tax penalty applies. In Quasar’s case, management must determine if any penalties would apply to the deduction for the partnership loss (since this is a listed transaction) and must make an accrual in the first reporting period after the 2007 tax year.³²

The IRS is expected to issue guidance³³ indicating that accrued interest expense under FIN 48 should be reported on the Schedule M-3, part III, line 8, and that interest expense and accrued penalty expense should be reported on part III, line 12, rather than on part III, line 2.

Incorporating the FIN 48 Analysis in the Federal Income Tax Accrual

After applying the provisions of FIN 48, the journal entry to reflect the tax accrual can be seen in Exhibit 9 (p. 32). Note that the federal income tax expense under FIN 48 is $73,100 greater ($2,249,355 with FIN 48 and $2,176,255 without FIN 48). This difference is composed of the following elements:

Tax liability without application of FIN 48	$2,176,255
Plus: Increase in taxes payable for uncertain partnership loss	13,600
Reduction in deferred tax asset for uncertain lawsuit	85,000
Less: Reduction in deferred tax liability for uncertain depreciation	(25,500)
Tax liability with application of FIN 48	$2,249,355

For reporting purposes, the deferred tax asset, the deferred tax liability, and the taxes payable should be separated into current and noncurrent amounts. In terms of a classified journal entry, the tax accrual shown above would be broken down as in Exhibit 10 (p. 32).

The $13,600 tax liability attributable to the partnership loss is reported as a noncurrent liability. Since there is no book-tax difference, the credit cannot be applied to the deferred tax liability account so it is applied to a noncurrent taxes payable account for an uncertain tax position. After applying FIN 48, Quasar has a current deferred tax asset of $6,800 from the bad debt expense and a noncurrent deferred tax asset of $90,100 from the following tax positions:

Capital loss carryover	$15,000
Lawsuit contingency loss	250,000
Total favorable tax positions	$265,000
	× .34
Noncurrent deferred tax asset	$ 90,100

This is offset by the $2,295 valuation allowance from the capital loss carryover. Quasar also has a deferred tax liability of $8,500 for the component depreciation ($25,000 × 34%).

After making this entry, Quasar’s finan-cial income statement shows a federal income tax expense of $2,249,355.³⁴ The federal tax liability from Form 1120, U.S. Corporation Income Tax Return, line 31, equals the amount on Schedule M-3, part III, line 1(a), and is eliminated as a permanent difference in column (c). The deferred tax expense is reported on part III, line 2(a), and is eliminated as a permanent difference in column (c). The deferred tax assets and liabilities are reported on the balance sheet, not on Schedule M-3, part III, line 2 (see appendix B).

It is interesting to compare the pre- and post-FIN 48 tax expense. The financial tax expense is larger ($2,249,355 vs. $2,176,255) and the deferred tax assets are smaller ($181,900 vs. $96,900). This result is likely to occur when applying FIN 48’s two-step process because less than 100% of the benefit of an MLTN position is recognized.

Management must determine the quantitative and qualitative disclosures to be made in the notes to the financial statements as mandated by FIN 48. Would the following disclosure be sufficient?

Financial tax expense was increased by approximately 3% as a result of applying FIN 48 to future tax benefits resulting from depreciation and partnership loss deductions, and costs associated with settlement of ongoing litigation.

Some might believe that this disclosure is too detailed, while others might think more disclosure is warranted.³⁵

Subsequent Recognition, Derecognition, and Measurement

FIN 48 requires a detailed reevaluation of all tax positions at the end of each subsequent reporting period (i.e., quarter or year). Prior positions must be reviewed for possible:

• Derecognition, if the MLTN standard no longer is met;
• Recognition, if old positions now meet the MLTN requirement; and
• Remeasurement, if new information would change the computation of the recognized amount.

Thus:

Subsequent changes in judgment that lead to changes in recognition, derecognition, and measurement should result from the evaluation of new information and not from a new evaluation or new interpretation by management of information that was available in a previous financial reporting period.³⁶

In addition, interest and penalties on the uncertain tax positions begin to accrue in accordance with relevant tax law in each subsequent reporting period. This may require complex computations with interest accruing from the original due date of the return, including possible interest netting from overpayments of prior years’ tax liabilities.³⁷

Implications

The first step in complying with FIN 48 is to create an “inventory” of uncertain tax positions as of the beginning of the first reporting year. Thoughtful guidance will be needed on issues concerning the second year of FIN 48 disclosures: How does the taxpayer construct a detailed “roll forward” reconciliation with the deferred tax balance sheet items as of the end of the prior year? How are true-up adjustments handled? What type of disclosures must be made to add or remove tax items from the prior year’s accounts? These adjustments might relate to law changes, judicial developments, or changes in the taxpayer’s attitude toward managing its tax risk.

Other changes may occur in a post-FIN 48 tax world. The Service’s somewhat benign attitude of restraint toward the discovery process for tax accrual workpapers could change as FIN 48 issues surface. Workpapers might be requested to explain information contained in a tax footnote to an SEC-required filing or to support the separation of the federal tax expense into its current and noncurrent components on Schedule M-3, part III, lines 1 and 2. According to one IRS official:

In my opinion, the IRS would not want to be lessening the impact of transparency of financial information because of its tax accrual workpaper policy.³⁸

The Service’s policy on this topic seems to be in flux, based on comments by two IRS officials at the March 9, 2007, meeting of the Federal Bar Association Taxation Section in Washington, DC.

We really have to wait and see how FIN 48 plays out and what kinds of disclosures are made … in deciding what issues to examine [on the tax accrual workpaper policy].³⁹

We’re not changing the [tax accrual workpapers] policy. We’re not currently looking to change the policy. I want to make that clear.⁴⁰

Under current IRS policy, requests for taxpayer workpapers are mostly limited to tax shelter issues. However, the Service has expressed an interest in reviewing the computations underlying the effective tax rate disclosed in the financial statements. Disclosure policies such as the one on tax accrual workpapers become even more problematic when a multinational taxpayer has relevant documents that reside (or affect tax computations) in more than one taxing jurisdiction.

Conclusion

It is the role of the IRS, not the taxpayer, to uncover the most taxpayer-friendly applications of the tax law and to apply audit tests so as to maintain the integrity of the tax system—first allowing the taxpayer to have its own say in resolving uncertainties as the tax law evolves. Even in a post-Enron world, there is the broader issue of layering the FIN 48 financial accounting process on top of the complex Schedule M-3 tax reporting requirements. The legacy of this combination may eventually be remembered not so fondly as classic financial and tax reporting overkill.

For more information about this article, contact Professor Raabe at raabe@fisher.osu.edu.

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Notes

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).

¹⁰ Drucker, “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).