Fin 48: Uncertain Tax Positions Associated With Transfer Pricing.

As a result of limited authoritative literature under United States ("U.S.") Generally Accepted Accounting Principles ("GAAP"), there has been a perception that significant diversity in the accounting for uncertain tax positions in the practice has developed over time. In the current U.S. business and accounting environment, this diversity has raised many concerns, including:

That the standards for recording tax benefits needed strengthening to provide a level of comparability;

A perception that tax contingency reserves had become too flexible and susceptible to earnings manipulation; and

The reporting and disclosure of taxes in financial statements were often opaque and misunderstood.

The U.S. Financial Accounting Standards Board ("FASB") undertook a project more than two years ago to address these concerns. The project concluded with the issuance of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("FIN 48"), dated June 2006 and released July 13, 2006. On January 17, 2006, the FASB unanimously affirmed its previous decision to make FIN 48 effective for fiscal years beginning after December 15, 2006. Accordingly, companies with calendar year-ends need to adopt the provisions of FIN 48 as of January 1, 2007.

The nature of the transfer pricing arm's length standard existing under section 482 of the Internal Revenue Code and the Treasury Regulations thereunder ("the section 482 Regulations"), the Guidelines for Multinational Enterprises issued by the Organisation for Economic Cooperation and Development ("the OECD Guidelines") and many individual local country transfer pricing rules and regulations, provide unique challenges in the application of FIN 48.

This document provides some answers to frequently asked questions around FIN 48 and transfer pricing from a global perspective.

Question 1: Broadly, what does FIN 48 prescribe?

Answer: FIN 48 prescribes a comprehensive model for how an entity should recognize, measure, present and disclose in its U.S. GAAP financial statements the impact of uncertain tax positions that management has taken or expects to take on tax returns (including a decision whether to file or not to file a return in a particular jurisdiction). In applying FIN 48, management will need to determine and assess all material uncertain tax positions existing as of the date they adopt the interpretation, in all jurisdictions for all tax years that are still subject to assessment or challenge under relevant tax statutes. Management is required to assess uncertain tax positions under the presumption that the position will be examined by the relevant tax authorities and that the authorities will have access to all relevant facts. Core concepts under FIN 48 include:

Recognition: A tax benefit from an uncertain tax position may only be recognized if it is "more likely than not" that the position is sustainable based solely on its technical merits (i.e. excluding detection risk) and any relevant widely understood administrative practices,

Measurement: The tax benefit of a qualifying position is the greatest amount of benefit that is cumulatively greater than 50 percent likely of being realized, and

Subsequent recognition and measurement: The assessment of the recognition threshold and the measurement of the associated tax benefit are subject to change based on new information. Unrecognized tax benefits should be recognized (derecognized) in the period the position reaches (falls below) the recognition threshold, which may occur prior to final resolution of the matter.

Question 2: What and who does FIN 48 apply to?

Answer: FIN 48 applies to all entities utilizing U.S. GAAP that are subject to income taxes, including not-for-profit organizations that are subject to income taxes. It applies to all tax positions accounted for in accordance with FASB Statement No. 109, Accounting for Income Taxes ("FAS 109"), including:

Previously filed positions,

Expected filing positions,

Decisions not to file tax returns,

Decisions to exclude potentially taxable income,

Choices made in classifying a transaction as tax-exempt (e.g., non-taxable spin-offs), and

Tax positions acquired or assumed in business combinations.

Uncertainties related to taxes not accounted for under FAS 109 should continue to be accounted for under FASB Statement No. 5, Accounting for Contingencies.

Given that FIN 48 applies to all entities utilizing U.S. GAAP it will potentially apply to:

Foreign subsidiaries of U.S. entities,

Non-U.S. entities registered with the SEC, and

U.S. subsidiaries of foreign entities that prepare U.S. GAAP accounts.

As such, non-U.S. tax professionals will also need to become familiar with the requirements and application of FIN 48. The extent to which a parent entity's tax department relies on a local subsidiary finance department will depend on many factors including; the unique set up of an entity's global tax department, the resources available, the issues at hand and materiality levels for statutory account purposes. Local subsidiary finance personnel may be required to assist in ascertaining the facts surrounding an uncertain tax position from a local perspective and advising on the local tax authority approaches to such positions and potential settlement positions.

Question 3: Is the existence of a Transfer Pricing contemporaneous documentation report covering an entity's intercompany transactions sufficient basis to conclude that there are no uncertain tax positions associated with those transactions?

Answer: No. U.S. contemporaneous documentation reports typically conclude on the question of whether the taxpayer appears to have met the standards of reasonableness with respect to transfer pricing penalties which are set forth in section 1.6662-6 of the Regulations. Generally, transfer pricing documentation reports prepared under the OECD Guidelines and local country rules conclude on whether the taxpayer's results are consistent with the arm's length standard as promulgated under the relevant rules. These reports do not conclude on the particular likelihood of sustaining a position, the amount of a particular position that has a greater than 50 percent cumulative probability of being sustained, or whether there are alternative outcomes that might be expected to be asserted by the respective tax authorities

Accordingly, management may need to consider alternative transfer pricing methods or profit level indicators in their analysis of alternative settlement positions. The "best method" (as prescribed under the section 482 Regulations) for transfer pricing documentation is not necessarily the only method that should be considered. The "best method" analysis contained in transfer pricing documentation may describe only why a taxpayer did not choose the other methods (and should be protected from penalty exposure). Under FIN 48, management may need to review other methods and their results more closely.

Question 4: If a taxpayer's results fall within the arm's length range identified in their transfer pricing documentation report does that mean an uncertain tax position does not need to be recognized or measured?

Answer: No. Although a taxpayer's results on its intercompany transaction(s) may fall within an arm's length range of results, as defined under the relevant country rules and regulations, an uncertain tax position may still exist. This may occur where management believes that they may ultimately settle at some other amount within or outside of the range documented.

For example, a taxpayer's results for a particular year may fall at the lower quartile of a range of results for companies performing comparable functions. Management may determine (based on their best judgment of an outcome after considering relevant law, administrative practices, and facts and circumstances) that the largest amount of tax benefit that is cumulatively greater than 50 percent likely of being realized upon ultimate settlement with a tax authority, is the median of the range. Alternatively, the taxpayer may determine that the amount would be based on another transfer pricing method selected to test a taxpayer's results and/or a different profit level indicator.

Question 5: What factors should management consider in determining units of account for transfer pricing?

Answer: Uncertain tax positions are recognized and measured based on the appropriate unit of account for that position. Broadly, a unit of account is the level at which you expect to engage the tax authority with regards to a tax position. Thus, in determining what is a unit of account for FIN 48 purposes, management need to determine the appropriate level of disaggregation of the intercompany results and/or transactions. There are no bright line tests that can be relied upon. Instead management will need to consider the facts and circumstances surrounding each intercompany arrangement. Factors influencing the determination will include the treatment and disclosure of the position in taxpayer's tax returns, consideration of how the relevant tax authorities will examine the position, and the significance and materiality of the position to the management.

For example, a unit of account could consist of a particular intercompany transaction such as a management fee charge out to a foreign subsidiary. Alternatively, it could consist of the overall results of that foreign subsidiary if management expects that they would effectively settle with a tax authority on that basis. Given the disclosure requirements under FIN 48, units of account will generally be determined on separate jurisdictional bases and on a gross basis (e.g. before Competent Authority adjustments, as described below). Depending however, on the nature of the uncertain tax position, transactions or results could be combined in one unit. For example, if management determines that, say, the U.S. Internal Revenue Service ("IRS') is likely to adjust the total cost base of a management fee charge out to foreign subsidiaries, that cost base could form one unit of account.

Question 6: Are probability tables required for all uncertain transfer pricing positions and how are they prepared?

Answer: If there is more than one possible settlement position, a probability table may be appropriate to demonstrate the determination of the largest amount of tax benefit that is cumulatively greater than 50 percent likely of being realized upon ultimate settlement with a tax authority. Once management has identified alternative settlement positions associated with a particular transfer pricing tax position, it will then have to determine individual probabilities of each of these positions.

The assignment of probabilities to a particular outcome is not an exact science. This exercise will be heavily dependent on facts and circumstances around a particular transaction, management's experience and knowledge of the tax authority's position on particular transactions, the experience and knowledge of industry peers with respect to settlements and strategies, etc. Therefore, the likely route most companies may take with respect to transfer pricing positions is to evaluate the qualitative aspects of a possible outcome and assign varying probabilities to outcomes based on the factors outlined in the preceding paragraph. Transfer Pricing professionals can help management in identifying the factors to be considered and sharing their experience and knowledge of settlements with respect to a particular transaction in that geography or industry.

If the alternative settlement positions identified are points within an arm's length range of results of companies performing comparable functions, is it appropriate to apply probability percentages to the full range of results or the interquartile range of comparable results? The answer will depend on management's determination of whether the relevant tax authority would consider the full or interquartile range in reaching effective settlement.

Question 7: What is the impact of Competent Authority negotiations on Uncertain Tax Positions?

Answer: Competent Authority considerations add another layer of complexity to the measurement and disclosure of uncertain tax positions from a transfer pricing perspective. As discussed below, offsetting adjustments as a result of Competent Authority must be disclosed separately under FIN 48. In determining if a Competent Authority adjustment may be taken into account, management should consider issues such as:

What is the specific unit of account?

Which Competent Authorities are you dealing with?

What is the likelihood that management would actually pursue Competent Authority? What has been management's historical appetite for such negotiations? Is it likely to be pursued based on a cost/benefit analysis?

What is the likelihood of success in Competent Authority in that particular country? How controversial is the issue at hand, and how likely is it that resolution would be reached? What is management's experience with or knowledge of negotiations with the relevant Competent Authority?

What is the potential reduction in the adjustment, and/or would we get full offset in terms of credits?

The answers to these questions will, of course, depend on the specific facts and circumstances and management's assessment of the likelihood of success.

Question 8: Should Transfer Pricing related to uncertain tax positions be calculated and recorded on a gross or net basis?

Answer: As discussed above, transfer pricing adjustments may ultimately be settled through Competent Authority negotiations or involve other compensating adjustments. In measuring the amount of an uncertain tax position, management should separately evaluate any offsetting transaction, and record the corresponding tax payable (receivable) on a gross basis on the balance sheet. Specifically, unrecognized tax benefits (i.e., FIN 48 liabilities) from one jurisdiction may not be netted against a deferred tax asset or potential tax overpayment receivable from another jurisdiction, even if that asset or receivable relates to the same intercompany arrangement. From a profit and loss perspective the gross transfer pricing uncertain tax position is included in the disclosure of the aggregate amount of uncertain tax benefits, although both positions will enter into the determination of the effective tax rate. (Refer to FIN 48, para 21 and PwC Dataline 2007-01, Question 39 for further discussion.) Interest calculations would, similarly, be performed on a separate jurisdictional basis for the respective tax liabilities and assets.

Question 9: Will the disclosures under FIN 48 impact US and foreign transfer pricing audits?

Answer: FIN 48 requires both quantitative and qualitative disclosures including the:

Annual roll-forward of all unrecognized tax benefits set out in the form of a reconciliation of the beginning and ending balances of the unrecognized tax benefits on a worldwide aggregated basis;

Discussion of reasonably possible changes in the recognized tax benefits in the next 12 months; and

Description of open tax years by major jurisdictions.

Individual units of accounts and the basis of their calculation are not required to be disclosed in an entity's U.S. GAAP financial statements (which may be filed with the SEC or otherwise made publicly available). However, the entity's statutory auditors will likely want to see documentation supporting the recognition and measurement of uncertain tax positions as well as the determination of units of account. Management should consider the possibility that the documentation of their uncertain tax positions could be reviewed by a tax authority. Therefore, the generation of such documentation should be approached carefully.

Question 10: What documentation is necessary to support an entity's identification of and accounting for its uncertain tax positions associated with Transfer Pricing?

Answer: The form and detail of documentation required to support management's identification of and accounting for its uncertain tax positions associated with transfer pricing will depend on many factors including the nature of the uncertain tax positions, the complexity of the issues under consideration and the materiality of the dollar amounts involved. Management should consult with their external independent auditors to determine the level of required documentation.

Management should also consider the reasonableness and consistency of statements made and analyses contained in their transfer pricing documentation with their documentation for FIN 48 purposes. As mentioned previously, transfer pricing documentation studies typically conclude on whether the taxpayer's results are consistent with the arm's length standard, as promulgated under the relevant transfer pricing rules. These documentation studies will generally only meet local requirements and provide penaIty protection to the extent that the taxpayer has acted reasonably.

It is the nature of transfer pricing however, that taxpayers who establish intercompany prices in accordance with the arm's length standard, may nevertheless expect that, ultimately upon audit by a tax authority, they may settle upon a different price. It is appropriate therefore to recognize that there is a risk that a tax authority will not agree with a taxpayer's position, and that it is appropriate to account for that risk through the application of FIN 48.

Conclusion

Transfer Pricing by its very nature is uncertain in that it recognizes that there is an "arm's length range of results" rather than one arm's length result. FIN 48 will require management, and external advisors, to evaluate material uncertain tax positions, which for many organizations will be an extensive exercise, and will significantly increase their documentation requirements. FIN 48 may cause greater volatility in income statements as changes in assessments under FIN 48 are recognized discretely within income tax expense. Transfer pricing professionals will need to be intimately familiar with FIN 48 and future interpretive guidance and practice developments as they seek to apply the guidance in a very subjective area.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Ms Katherine Treasure

Pricewaterhouse Coopers LLP 

San Francisco 

California 

UNITED STATES

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