An early implementation guide to accounting for uncertain tax positions.

On July 14, 2005 the Financial Accounting Standards Board (FASB) published an Exposure Draft of a proposed Interpretation of FASB Statement No. 109, Accounting for Uncertain Tax Positions, to address what was perceived as significant diversity in practice in accounting for income taxes related to uncertain tax positions. (1) An early observation by tax and accounting practitioners was that implementation conceivably could require more effort by and resources of corporate tax departments than the requirements of section 404 of the Sarbanes-Oxley Act, relating to the documentation of internal controls.

As originally proposed, the Exposure Draft would have required a "probable" standard for recognition of tax benefits in the financial statements. FASB received 118 comment letters on the proposal. Tax Executives Institute, like many commentators, felt that the proposed Interpretation would be unduly complex, prove difficult to apply in practice, and result in systematic overstatement of tax liabilities. (2)

On November 22, 2005, FASB changed course and adopted a "more likely than not" standard to replace the original "probable" standard for tax benefit recognition. (3) Two months later, on January 11, 2006, FASB announced that the effective date of the final Interpretation will be the beginning of the first annual period beginning after December 15, 2006, or January 1, 2007, for calendar-year companies. (4)

Accounting for Uncertain Tax Positions

The proposed Interpretation, Accounting for Uncertain Tax Positions, defines a minimum recognition threshold that a "tax position" must meet to be recognized in a company's financial statements.

Tax Position

The proposed Interpretation defines tax position as an individual filing position in a previously filed tax return or an expected filing position reflected in measuring current or deferred income tax expense or benefit for interim or annual periods prior to filing a tax return. The term tax position also encompasses a decision not to file a tax return, a decision to exclude reporting a tax position in a tax return, or the choice made in reporting a transaction in a tax return. A tax position ordinarily would relate to a tax benefit, but could include failing to take an otherwise valid tax deduction.

Tax positions may result in tax benefits that either (a) reduce income tax expense and the associated income taxes paid or payable (including deferred tax liabilities) or (b) increase an income tax benefit and the associated income tax receivable, deferred tax asset, or income tax refund. A tax benefit can result from a permanent reduction of income taxes or the deferral of income taxes otherwise currently payable to future years.

The appropriate unit of account for a tax position is a matter of the individual facts and circumstances of that position evaluated in light of all available evidence. It is based on the manner in which a company manages its business, and on the financial and operational systems that are used to control the business. An example in the proposed Interpretation of four separate research projects states that the unit of account is the individual research project.

Confidence Threshold for Recognition

FASB Statement No. 109 does not explicitly prescribe a confidence threshold to be met for the benefit of an uncertain tax position to be recognized. FASB concluded that this absence of specificity resulted in diverse accounting practices and, in turn, inconsistency in the criteria used to recognize, derecognize, or measure benefits related to uncertain tax positions. According to FASB, this diversity in practice has resulted in noncomparability in reporting income tax expense that users of the financial statements cannot easily discern. The proposed Interpretation was proffered, at least in part, to produce greater comparability in financial reporting of income taxes.

As originally proposed, a company would have been required to recognize, in its financial statements, the best estimate of the effect of a tax position only if that position was probable of being sustained on audit based solely on the technical merits of the position. FASB has adopted a "more likely than not" standard to replace the original "probable" standard for tax benefit recognition. In evaluating whether the more-likely-than-not recognition threshold has been met, the proposed Interpretation would require the presumption that the tax position will be evaluated during an audit by taxing authorities.

Individual tax positions that fail to meet the more-likely-than-not recognition threshold will generally result in either (a) a reduction in the deferred tax asset or an increase in a deferred tax liability or (b) an increase in a liability for income taxes payable or the reduction of an income tax refund receivable.

Scope

The proposed Interpretation would broadly apply to all

tax positions accounted for in accordance with FASB Statement No. 109, including tax positions that pertain to assets and liabilities acquired in business combinations.

Initial Recognition

The recognition threshold presumes that a taxing authority will, during an audit, evaluate a tax position taken or expected to be taken when assessing recognition of an uncertain tax position. The proposed Interpretation discusses valuation versus validity. The more-likely-than-not standard is met when a deduction is valid under clear and unambiguous tax law, but the amount of the deduction might be in question.

A specific example is provided in the proposed Interpretation with respect to transfer pricing. If the pricing analysis is appropriately prepared with all facts objectively verifiable, all assumptions are reasonable and supportable, and the choice of the amounts to be recorded are reasonable and supportable, they would help to support management's best estimate for use in measuring the tax effects of the intercompany transactions in the financial statements of the consolidated entity and each of the subsidiaries.

Subsequent Recognition and Derecognition

A tax position not previously meeting the more-likely-than-not recognition threshold should be recognized in any later period in which the company subsequently concludes that the more-likely-than-not recognition threshold has been met. Recognition of the benefit should occur in the interim period that (a) the more-likely-than-not recognition threshold is subsequently met, (b) the tax matter is ultimately resolved through negotiation or litigation with the tax authorities, or (c) the statute of limitations has expired.

Likewise, a previously recognized tax position that no longer meets the more-likely-than-not recognition threshold should be derecognized by recording an income tax liability or reducing a deferred tax asset in the period in which the company concludes that it is more likely than not that the position will not be sustained on audit. A valuation allowance should not be used as a substitute for derecognition of the benefit of a tax position.

A company should recognize management's best estimate of the amount that would be sustained on audit based on information available at each reporting date.

Measurement

Once the more-likely-than-not recognition threshold is met, the best estimate of the amount that would be sustained on audit should be recognized. Any subsequent changes in the recognized amount should be made using a best estimate methodology and recognized in the period of the change.

Classification

The liability arising from the difference between the tax position and the amount recognized and measured should be classified as a current liability for amounts that are anticipated to be paid within one year or the operating cycle, if longer. Unless that liability arises from a taxable temporary difference, it should not be classified as a deferred tax liability.

Change in Judgment

A change in the recognition, derecognition, or measurement of a tax position should be recognized entirely in the interim period in which the change in judgment occurs.

Interest and Penalties

Accrual of interest and penalties should be based on the difference between the tax benefit recognized in the financial statements and the tax position in the period the interest and penalties are deemed to have been incurred. Classification of interest and penalties in the income statement was not considered when FASB Statement No. 109 was issued, and is not considered in the proposed Interpretation.

Disclosures

Loss contingencies relating to previously recognized tax positions should be disclosed in accordance with the provisions of FASB Statement No. 5, Accounting for Contingencies. An estimated loss is accrued if both (a) information available before the issuance of the financial statements states that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements, and (b) the amount of the loss can be reasonably estimated.

If no accrual is required, disclosure of the contingency should be made when there is at least a reasonable possibility that a loss may have been incurred. An event is reasonably possible if the chance of occurrence is more than remote but less than likely.

Effective Date and Transition

The proposed Interpretation is to be applied to all tax positions for which the statute of limitations remains open upon initial adoption of the Interpretation. Only tax positions meeting the more-likely-than-not recognition threshold at the effective date may be recognized.

The cumulative effect of initially applying the proposed Interpretation would be recognized as a change in accounting principle as of the end of the period in which the proposed Interpretation is adopted. Restatement of previously issued interim or annual financial statements and pro forma disclosures for prior periods is not permitted. Earlier application is encouraged by FASB.

Materiality 

The provisions of the proposed Interpretation need not be applied to immaterial items. No definition of materiality is provided.

Two-Step Process

Evaluating a tax position is a two-step process, described by FASB as a benefit recognition model. The first step is evaluation for recognition, which is the determination that the tax position is valid under the relevant tax law. If the recognition threshold is met, then the position is considered valid.

The second step is measurement of the amount of benefit to be recognized in the financial statements.

Early Implementation Guide

Absent further guidance from FASB, the following is suggested as an early implementation guide.

1. Using the most recently-filed corporate tax return, create a work sheet of page 1 of Form 1120 for income, deductions, tax, and payments for each company in the consolidated group.

2. Identify potential uncertain tax positions. A checklist is set forth in the following section of this article.

3. Identify the effect of the potential uncertain tax position as an increase or decrease to book income.

4. Reference the source of the potential uncertain tax position.

5. Provide a description of the potential uncertain tax position.

6. State whether the more-likely-than-not threshold is met for tax benefit recognition.

7. State whether initial recognition is appropriate.

8. In future periods, state whether subsequent recognition or derecognition is appropriate.

9. State the best estimate of the amount that would be sustained on audit.

10. Classify as current or noncurrent the liability arising from the difference between the tax position and the amount recognized and measured.

11. Prepare appropriate financial statement disclosures.

A narrative description of the evaluation process for each potential uncertain tax position should be prepared.

Checklist for Identification of Potential Uncertain Tax Positions

1. Form 1120 U.S. Corporation Income Tax Return. Schedule M-3 items, Form 8886 Reportable Transaction Disclosure Statement, elections, and disclosures should be reviewed.

2. State and Local Income and Franchise Tax Returns. Review state and local income and franchise tax returns for potential uncertain tax positions such as allocation, apportionment, and business versus nonbusiness income issues. Consider potential nexus issues for unfiled returns.

3. Tax Return Work Papers. Review Schedule M-3 workpapers for potential uncertain tax positions.

4. Tax Provision Work Papers. Review tax provision work papers for potential uncertain tax positions.

5. IRS and State Audits. Review IRS and state audit information document requests, notices of proposed adjustments, and settlements for potential uncertain tax positions.

6. Sarbanes-Oxley Section 404 Documentation. Review documentation of tax internal controls to identify sources of potential uncertain tax positions.

7. Internal Interviews. Consider interviews with legal, financial, and business management to identify corporate transactions that might indicate potential uncertain tax positions.

8. Internal Audit Reports. Review internal audit reports for discussions of potential uncertain tax positions.

9. Accounting Manual. Review the corporate accounting manual to identify procedures for recording transactions that might indicate potential uncertain tax positions.

10. Audit Committee and Board of Directors Minutes. Review audit committee and Board of Directors minutes to identify transactions that might indicate potential uncertain tax positions.

11. SEC Filings. Review Form DEF 14A definitive proxy statements, Forms 8-K for material events, Forms 10-Q and 10-K quarterly and annual reports. Income tax footnotes and Management Discussion and Analysis should be reviewed for potential uncertain tax positions.

12. Tax Law Changes. Tax law changes, both new and expiring provisions, should be reviewed for potential uncertain tax positions.

13. Industry Issues. Industry issues should be reviewed. An excellent source of industry issues is the industry sessions held at Tax Executives Institute's Midyear and Annual Conferences.

14. External Auditor Meetings. Discussions with external auditors should be initiated to review potential uncertain tax positions and required documentation and audit evidence.

(1) Financial Accounting Standards Board, Reference Number: 1215-001, Accounting for Uncertain Tax Positions--An Interpretation of FASB Statement No. 109 (July 14, 2005).

(2) Letter from Michael P. Boyle, President of Tax Executives Institute, to Robert H. Herz, Chairman of Financial Accounting Standards Board (September 12, 2005).

(3) Financial Accounting Standards Board, Minutes of the November 22, 2005, Board Meeting--Uncertain Tax Positions: Scope, Recognition, and Measurement (December 7, 2005).

(4) Financial Accounting Standards Board, Minutes of the January 11, 2006, Board Meeting--Uncertain Tax Positions: Subsequent Recognition and Measurement, Change in Judgment, Interest and Penalties, Classification, Transition and Effective Date (January 20, 2006).