TEI files comments on uncertain tax positions: September 12, 2005.
As President of Tax Executives Institute, I hereby submit the following comments on the Financial Accounting Standard Board's Exposure Draft of a Proposed Interpretation on Accounting for Uncertain Tax Positions, Reference No. 1215-001. The proposed Interpretation was issued on July 14, 2005, to clarify when the tax benefits of uncertain tax positions should be recognized in the financial statements of an issuer.
TEI shares the FASB's interest in maintaining the integrity and vitality of the financial reporting system of which the provision for taxes, at the federal, state, and local levels in the United States, and for foreign levies as well, is a material part. TEI also supports the FASB's goal of achieving greater comparability of financial statements and consistency in the measurement and reporting of tax expense, liabilities, and assets. Finally, we support the efforts of the FASB to ensure that the issuers' financial statements, taken as a whole, faithfully present the issuers' tax positions and provide the most useful information to investors.
Tax Executives Institute is the preeminent global association of corporate tax executives. Our more than 5,400 members are accountants, attorneys, and other business professionals employed by approximately 2,800 of the leading companies in the United States, Canada, Europe, and Asia. TEI represents a cross-section of the business community, and is dedicated to the development and implementation of sound tax policy and to promoting the uniform and equitable enforcement of the tax laws. The Institute is proud of its record of working with congressional committees, government agencies, and other policy-making bodies (including the Public Company Accounting Oversight Board and the Securities and Exchange Commission) to minimize the cost and burden of tax administration and compliance to the mutual benefit of the government, business, and ultimately the public. We also support efforts to ensure that companies fairly present their financial position in financial statements prepared for investors and in documents filed with the SEC.
TEI members are responsible for conducting the tax affairs of their companies and ensuring their compliance with the tax laws. Thus, members deal with the tax code in all its complexity, as well as with the Internal Revenue Service, on a daily basis. All or nearly all the companies represented by our members issue financial statements that are governed by the FASB's pronouncements and most are SEC registrants. In addition, they are subject to scrutiny by the IRS and various other agencies in the United States and foreign jurisdictions on a continual basis.
As a professional association of in-house tax executives, TEI offers a different perspective on the issues from other organizations. TEI's members work directly for corporations that routinely enter into business transactions requiring an analysis of their tax benefits and burdens. These companies have professional staffs dedicated to ensuring compliance with the tax law while minimizing their tax liability. TEI members and their staffs are responsible for ensuring the quality, reliability, and documentation of their companies' internal controls for the proper financial accounting and reporting of tax expense, tax assets, and tax liabilities under section 404 of the Sarbanes-Oxley Act.
Hence, we believe that the diversity, background, and professional training of TEI's members place us in a uniquely qualified position from which to comment on the Board's exposure draft on the recognition and measurement of uncertain tax positions. Along with the government and the investing public, our members have the most at stake in trying to craft a financial reporting system that fairly presents the results of company operations and is as administrable and efficient as possible. We are pleased to submit the following comments.
Summary of TEI's Comments and Recommendations
The proposed Interpretation, which would substantially modify FAS 109, (1) provides a theoretical approach for the consistent determination and reporting of income tax liabilities, assets, and expense relating to uncertain tax positions. While supporting the FASB's general goals, TEI does not believe the proposed Interpretation should be adopted. Indeed, because the asset recognition model is fundamentally flawed, we believe the proposed Interpretation would neither represent an improvement over current accounting principles nor produce greater consistency and comparability of financial statements.
In addition, the dual standard for recognition and derecognition of tax benefits--and the corresponding resources required to document whether an enterprise satisfies the dual recognition standards--will impose substantial implementation and ongoing costs on financial statement issuers without enhancing the reliability of the financial statements. As important, the threshold determination undergirding the proposed Interpretation--that tax positions should not be recognized unless they are "probable" (as defined in the proposed Interpretation) of being sustained on audit based solely on the technical merits of the position--is at odds with pragmatic, prudent tax judgments that financial statements should reflect. Hence, TEI agrees with the views expressed by the Board members who said that the proposed Interpretation would (a) be unduly complex, (b) prove difficult to apply in practice, and (c) result in systematic overstatement of tax liabilities. (2)
TEI believes that the FASB's goal of improving consistency in the recognition and measurement of tax benefits of uncertain tax positions can be achieved through the adoption of an approach based on current accounting principles governing contingent liabilities, including taxes, under FAS 5. (3) Thus, TEI recommends that the proposed Interpretation be withdrawn and that the FASB consider the recommendations and comments below for improving perceived deficiencies in current accounting principles. Alternatively, in the event the FAS 5 approach is not retained, we offer several recommendations for improving the proposed Interpretation's asset recognition model.
Finally, if an asset recognition model is adopted, the effective date should be substantially delayed until the later of six months following release of the Interpretation or years ending after December 15, 2006. Analyzing and computing the cumulative effect of the accounting change to implement the far-reaching effects of a fundamental change in the recognition of all tax positions as well as making the necessary process control changes to comply with the documentation and testing requirements of section 404 of the Sarbanes-Oxley Act will require substantial time and resources for all companies, especially those operating on a global basis.
TEI's principal concerns about and comments upon the proposed Interpretation are addressed in the body of this letter. Responses to the 11 issues identified in the notice to recipients of the Exposure Draft are set forth in the Appendix.
Accounting for Tax Positions Should Reflect Pragmatic Tax Judgments
Given the complexity and ambiguity inhering in federal, state, and foreign tax rules, as well as companies' obligation to legitimately minimize costs, disputes with tax authorities about reported liabilities are routine. Whereas the specific issues will vary by enterprise and tax jurisdiction, the effect on the financial statement tax accrual process is the same:
In-house tax advisers make an assessment--an informed but ultimately subjective judgment--of the nature of the issues and the scope and degree of potential and actual controversies with applicable tax authorities about the proper interpretation of the law. The judgment reflects a careful analysis of--
* the strengths and weaknesses of an enterprise's internal control, tax compliance and financial statement reporting processes;
* the soundness of the enterprise's tax treatment of routine and unusual transactions;
* the merits of the legal authorities supporting the enterprise's position on identified transactions or issues (as well as the absence of comprehensive guidance on many issues); and
* where a dispute is likely, the negotiation and litigation strategies the enterprise can employ to resolve an issue.
Based on our members' experience in managing federal, state, and foreign tax audits and resolving disputes, TEI disagrees with the proposed Interpretation's presumption that a taxing authority will examine all tax positions, assert a claim, and disallow every tax position that is not supported at a "probable" level of confidence. There are many tax positions --including positions supported by substantial authority or higher levels of confidence--that do not warrant scrutiny by taxing authorities or are unlikely to be reviewed. Nonetheless, nearly all large companies assume that material tax positions or significant transactions will be evaluated by the relevant taxing authorities and challenged where there is a reasonable basis for disallowing an enterprise's position. (4) Requiring an accrual for disallowance of tax positions that the enterprise "knows" (based on experience) are not of concern to the tax authorities even though a probable level of confidence cannot be satisfied, will overstate tax liabilities and expense. (5)
Fundamentally, TEI does not agree that a presumption that tax positions will be detected and examined should give rise to a correlative presumption, under all circumstances, that the taxing authority will assert a sustainable, contrary position and, as a result, that no benefit should be provided for the tax position unless the enterprise satisfies a "probable" level of confidence. Under current accounting principles, the risk that a taxing authority will challenge a position taken on a tax return is generally treated as an unasserted claim under FAS 5 paragraphs 10 and 38.
Hence, an enterprise first determines whether the assertion of a claim (i.e., a proposed disallowance of the tax position) is probable. Where assertion of the claim is probable, a reserve is accrued for the estimated amount of the loss. If it is not probable that the taxing authority will disallow the tax position, no accrual or disclosure for the potential disallowance is required. This approach is consistent with the determination of the estimated amount of losses from other contingencies and, in our view, there is no basis for adopting a different model solely for income tax liabilities. If the FASB concludes there is inconsistent accounting for income taxes or that an impairment approach is inconsistent with paragraph 38 of FAS 5 (because enterprises might inappropriately consider the risk of audit detection for unasserted claims related to income taxes), it should issue a clarification of FAS 5 rather than adopting an entirely new model. A recommended approach is discussed below.
Retain and Affirm Current Accounting Principles, including the FAS 5 Approach to the Determination of Contingent Tax Liabilities
TEI believes that current accounting principles are straightforward, provide proper accounting for uncertain tax positions, and balance the potential for understatement or overstatement of tax expense, assets, and liabilities. In contrast, the proposed Interpretation is unnecessarily complex and will lead to improper accounting results in many circumstances. (6) The proposed Interpretation notes that inconsistencies have arisen in the application of current accounting principles to uncertain tax positions. If so, TEI believes the solution lies in clarification of the current principles and consistent enforcement of the modified rules rather than wholesale adoption of a new and over-conservative standard for recognition of tax benefits.
When the tax benefit of a deduction or credit is claimed on a tax return, an enterprise pays less cash to the government and retains control of the "benefit" until the taxing authority asserts a sustainable claim. Since income taxes are generally self assessed, the primary uncertainty about the benefit is whether the taxing authority will assert a sustainable, post-filing claim that the enterprise owes an additional liability. This is conceptually similar to other claims addressed by FAS 5. In addition, viewing income tax benefits as "assets" under CON 6 raises theoretical problems. (7) Unpaid taxes are a liability and challenges by a tax authority to an enterprise's uncertain tax positions are fundamentally about whether an asset (i.e., the amount of cash not paid to the taxing authority) is impaired or an additional liability will be incurred. The issue is not whether an asset should be recognized, but rather whether a liability exists for uncertain tax positions as already governed by FAS 5. Finally, the proposed Interpretation's asset model will not faithfully present the expected cash flows from an enterprise's tax positions. For these reasons, adoption of the proposed Interpretation's asset recognition model will be exceedingly confusing and unduly complex for financial statement issuers to apply and will not supply meaningful information to readers.
On the other hand, FAS 5 provides a better approach for making the proper determination of an additional liability. Although enterprises may adopt different approaches to determining the amount of loss to accrue under FAS 5, the consistent objective is to estimate the amount of tax benefit that will be confirmed on resolution of a challenged tax position. Moreover, the required level of confidence for an uncertain tax position may vary depending on the nature of the tax position and the applicable facts and circumstances, but this variation reflects a prudent exercise of judgment. (8) Concededly, current rules permit enterprises to exercise judgment about their expected tax liabilities, which may result in inconsistent judgments among reporting enterprises, but that is a reflection of the complexity, ambiguity, and uncertainty of the tax laws; it is not evidence that the current rules should be replaced with a new model based on mechanical, arbitrary, and inflexible rules that will lead to systematic overstatement of tax liabilities. (9)
TEI recommends that the FASB confirm that in applying FAS 5 to tax liabilities an enterprise need not accrue a loss for the potential disallowance of a tax position (regardless of the level of confidence that the position would be sustained if challenged) unless it is probable that the position will be challenged and disallowed by the relevant taxing authority. The recommendation (1) reflects the view that loss contingencies for income taxes are subject to the same rules that apply to loss contingencies arising from other potential disputes and (2) requires an assessment of the probability that a party will assert a claim as prescribed in FAS 5 paragraph 38.
Implicit in the proposed Interpretation is a concern that enterprises might overstate tax benefits by making unreasonable assumptions about audit detection risks or taking speculative positions. (10) If guidance is needed in these areas, TEI supports a presumption that, when applying FAS 5 paragraph 38 to loss contingencies related to tax positions, the enterprise must assume that (1) it is probable that a position will be examined by the relevant taxing authority and (2) the position will be challenged if there is a reasonable basis for a challenge. (11) If the criteria are satisfied, a loss based on a reasonable estimate of the tax liability to be incurred should be accrued. TEI's proposed presumption would be consistent with current accounting practice for large companies (and likely most SEC registrants), which assume that material tax positions will be examined on audit and challenged where there is a reasonable basis for the challenge. (12)
Initial Recognition Threshold--Probable Standard
The proposed Interpretation would permit an enterprise to "recognize the financial statement effects of a tax position when that position is probable of being sustained on audit by the taxing authorities based solely on the technical merits of the position." (13) The proposed Interpretation explains that "the term 'probable' is used in the sense of paragraph 3(a) of FAS 5 to mean that 'the future event or events are likely to occur.'" Moreover, the proposed Interpretation would apply to all tax positions, not just "uncertain" tax positions.
Regrettably, the proposed Interpretation's usage of "probable" is confusing because the ordinary dictionary sense of "probable" is "likely to occur." Thus, although a "more likely than not" level of confidence might be expected to satisfy the recognition standard, the proposed Interpretation explains that the "probable" level of confidence is intended to be "consistent with its use in paragraph 3(a) of FAS 5...." In addition, the term "probable" in FAS 5 "does not mean virtually certain [but] is a higher level of likelihood than 'more likely than not.'" (14) Audit firms and enterprises have generally adopted a rule of thumb that a "probable" level of confidence under paragraph 3(a) of FAS 5 requires a 70- to 75-percent likelihood. Similarly, tax practitioners consider a tax position "probable" of being sustained if the likelihood of prevailing on the merits of an issue is 70 to 75 percent.
Under the proposed Interpretation, an enterprise must satisfy a stringent evidentiary burden in order to establish a probable level of confidence in the validity of its tax position. Specifically, paragraph 9 states that, in the absence of opposing evidence, the following factors demonstrate a "probable" level of confidence in the validity of the tax position:
a. Unambiguous tax law supporting the position.
b. An unqualified should prevail tax opinion from a qualified expert for which all conditions are objectively verifiable. (15)
c. Similar positions in prior years' tax returns that have been obviously presented in the tax returns and have been either accepted or not disallowed or challenged by the taxing authorities during an examination.
d. Legal precedents from similar positions taken by other taxpayers, where analogy is appropriate, that have been favorably resolved through litigation with taxing authorities. (16)
No priority is assigned to the factors.
Fundamentally, the proposed threshold for initial recognition of tax benefits is unworkable. The requirement that tax benefits must satisfy, in effect, a "should-prevail" level of confidence for initial recognition of tax benefits will systematically overstate tax expense and tax liabilities (or understate tax assets) in certain periods and create gains in subsequent periods when the statute of limitations expires (or an examination is concluded and the matter resolved). As important, the requirement to base the probable level of confidence solely on the technical merits of the position and without consideration of the possibility of offset or aggregation with other positions is artificial and not meaningful for tax practitioners. The standard ignores how tax positions are assessed and controversies are resolved.
In addition, the evidentiary factors set high thresholds and the recognition standard conflicts with the reality of how tax issues are analyzed and controversies are settled. (17 )The tax laws governing a company's transactions and reporting positions are hardly a model of clarity or precision. Hence, qualified tax professionals often disagree about the application of statutes, regulations, and court decisions to specific transactions or facts and circumstances. Even commonplace, routine, and recurring expenditures such as repairs are frequently subject to challenge by tax authorities as capital expenditures. As a result, factors (a) and (d) above can rarely be satisfied at a "probable" level of confidence.
In respect of factor (c), it is unclear why an enterprise cannot rely upon the same presumption of detection that underlies the proposed Interpretation. In other words, what is intended by the requirement that a prior position have been "obviously" presented by the enterprise? How is an item "obviously" presented? When a tax form is filled out in accordance with the taxing authorities' instructions? Or does the "obviously" presented requirement require that taxpayers undertake additional disclosures? When an item is shown on a return, should it not be deemed "obviously presented"? Does "acceptance" by the taxing authority of an "obviously presented" position require specific examination of the issue? If so, what level of scrutiny is required during the examination? Is a cursory survey of a tax return an examination or must the taxing authority issue information document requests in respect of an item on the return? These are but a few of the questions that will arise in assessing whether an enterprise can satisfy factor (c) in order to recognize a tax benefit. Hence, although there is no requirement under the proposed Interpretation to obtain tax opinions, the "should prevail" standard could become the operational test.
Moreover, TEI questions whether the proposed Interpretation is consistent with the general requirements in CON 6 for the recognition of assets. First, the general test for recognition of assets or liabilities under CON 6 is "probable" in the "usual general" sense of the term rather than "probable" as used in a "specific accounting or technical sense ... such as in FASB Statement No. 5." (18) Thus, "probable" in the "usual general" sense of CON 6 implies a standard no higher than a "more likely than not" level of confidence.
Second, the proposed Interpretation seemingly diverges from both CON 6 and FAS 5 by limiting the evidence an enterprise may consider in assessing the likely outcome of a tax controversy. Under the proposed Interpretation, an enterprise is to assess the validity of its tax position "based solely on the technical merits of the position." In addition, an enterprise may not consider the possibility of offset or aggregation of one tax position with others. Such pragmatic considerations, however, should not be excluded from an evaluation of whether a tax position is sustainable. Indeed, the consideration of informal administrative practices, including the enterprise's prior settlement experience and the settlement experience of others, often supplies a high level of confidence that a position can be sustained. (19) For example, if an issue resolution approach is questionable but nevertheless understood to be commonly accepted by the taxing authority (during audits or appeals), should not an enterprise be permitted to take account of the pragmatic result in accruing its tax liabilities? (20) In addition, in many tax controversies (e.g., capitalization or deduction of repair expenditures, qualification of projects for the research and experimentation credit), enterprises and taxing authorities routinely aggregate similar or related tax issues when considering the hazards of litigation and negotiating the resolution of issues.
Accordingly, TEI disagrees with the probable standard because it would lead to systematic overstatements of tax liabilities compared with an enterprise's best, reasonable estimate of the likely outcome of its tax positions. Tax liabilities (and expense) would be overstated (and net income understated) when a position is established; correspondingly, tax liabilities (and expense) will be understated (and net income overstated) when tax matters are resolved or the statute of limitations expires. Hence, we urge the FASB to withdraw the proposed Interpretation and reconsider the asset recognition model.
In the event that the asset recognition model is retained, we have several recommendations for changes in the recognition threshold.
First, TEI recommends permitting the recognition of benefits for tax positions that satisfy the applicable legal threshold necessary to avoid the imposition of statutory penalties for underpayment of taxes. (21) For example, if the standard for proper reporting of an item on a tax return is "substantial authority" or "reasonable basis," the amount of tax benefit represented by the position should be recognized as long as the taxpayer can demonstrate that minimum legal level of confidence in its position. (22) Under this approach, the standard for recognition of tax benefits for financial reporting would reflect and align with the tax reporting standards of the various jurisdictions where the company files tax returns. Alternatively, the standard for recognition of a benefit from a tax position should be no higher than a "more likely than not" level of confidence? (23) A "more likely than not" level of confidence should be sufficient for recognition of the benefit in the financial statements because that amount would represent the enterprise's best estimate of what it believes the tax outcome will ultimately be.
Second, if a lower threshold for asset recognition is adopted, an even lower threshold for derecognition of tax benefits would be unnecessary. Although we are concerned that a small change in the assessment of the probability of prevailing on the merits of a tax issue will cause a substantial change in the amount of benefit to be recognized, the concern is evidence of the fundamental flaw in the asset approach rather than an issue to be resolved by adoption of a lower threshold for derecognition.
Finally, there is also little or no practical guidance available in respect of how enterprises should document--to the satisfaction of their auditors and the SEC under section 404 of Sarbanes Oxley--whether a tax position satisfies the "probable" level of confidence.
Effective Date and Transition Rule
The proposed Interpretation would be effective for fiscal periods ending after December 15, 2005. In addition, the proposed Interpretation would be applied upon adoption to all tax positions for which the statute of limitations remains open. Thus, only tax positions that satisfy the "probable" standard would be recognized or continue to be recognized. The cumulative effect of the change would be reflected as of the end of the period in which the Interpretation is adopted. In effect, tax positions that do not satisfy the probable standard and have been previously recognized in an enterprise's financial statement would be derecognized.
TEI agrees that transition rules should be provided, but submits that the probable threshold for initial recognition of tax benefits should not be applied to tax positions reflected in the financial statements as of the effective date. Rather, if the dual threshold and probable standard for recognition are retained, TEI recommends that tax positions in the financial statements at the effective date be subject to derecognition only in accordance with paragraph 10 of the proposed Interpretation. In other words, uncertain tax positions at the effective date should be derecognized only if they fail to satisfy the "more likely than not" level of confidence that the proposed Interpretation would require for derecognition on an ongoing basis. Previously recognized positions should be adjusted as necessary to conform to the best estimate measurement rule of the proposed Interpretation (as modified by TEI's recommendations). (24) More important, TEI recommends that the effective date for the proposed Interpretation be delayed substantially. By adopting an asset recognition model for tax benefits, the proposed Interpretation would turn the analysis of an enterprise's tax positions, i.e., liabilities, on its head. As a result, we can understand why the FASB's deliberations extended for a significantly longer period than anticipated when the December 15, 2005, effective date was initially discussed. Enterprises, however, should not have to incur the costs of a rushed implementation prompted by the FASB's delay. This is especially the case since analyzing and computing the cumulative effect of the accounting change, as well as making and testing the necessary tax provision process and information system control changes to comply with section 404 of the Sarbanes-Oxley Act, will require substantial time and resources. Indeed, since the proposed Interpretation would require an analysis and documentation of whether a worldwide enterprise's positions in all open tax years and jurisdictions satisfy a "probable" threshold, we believe that far more than three months from the close of the comment period to the proposed effective date will be required. (25) Moreover, the implementation of FAS 123-R has a significant tax effect that companies must adopt and transition to by the end of the first quarter of 2006. (26)
In order to afford issuers a reasonable amount of time to study the Interpretation and implement it effectively, TEI recommends that the effective date for the Interpretation be delayed until the later of fiscal years ending after December 15, 2006, or six months following release of the Interpretation.
TEI appreciates the opportunity to comment on the proposed Interpretation and would be pleased to discuss its comments with the FASB. These comments were prepared under the aegis of TEI's Financial Accounting Task Force, whose chair is Neil D. Traubenberg. If you should have any questions about the comments, please do not hesitate to contact Mr. Traubenberg at 303.673.3904 or email@example.com or Jeffery P. Rasmussen of the Institute's legal staff at 202.638.5601 or firstname.lastname@example.org.
Appendix--Issues Raised by the Board in the Exposure Draft
The notice to recipients of the exposure draft requests comment on the resolution of 11 issues. TEI's comments address those issues (and the related questions) seriatim.
The proposed Interpretation would apply broadly to all positions accounted for in accordance with FAS 109, (27) including assets and liabilities acquired in a business combination and tax positions taken in returns or positions to be taken in future returns.
TEI agrees that the accounting standards applicable to tax positions that pertain to assets and liabilities acquired in a business combination should be consistent with the accounting for tax positions that arise from a company's ongoing business operations. Deferred taxes for assets and liabilities acquired in a business combination are generally provided based on the "best estimate of the tax basis of the acquired assets and liabilities that will be accepted by the tax authority." (28) The application of the current FAS 109 "best estimate" standard to business combinations is also generally consistent with the current accounting principles for measuring tax assets and liabilities in other contexts. Thus, although TEI does not believe that the standard for recognition of tax positions set forth in the proposed Interpretation should be adopted, we agree that the standard for measuring tax assets and liabilities should be consistent regardless of the origin of the assets and liabilities. (29) TEI believes the best estimate method would provide the most useful information to financial statement users.
2. Initial Recognition--Audit Detection Risk
The proposed Interpretation would require an enterprise to presume that the relevant taxing authority will, during an audit, evaluate a tax position taken or to be taken when assessing whether to recognize the benefit of a tax position.
TEI agrees that enterprises should assume that the taxing authorities will evaluate all material tax positions. That said, we do not agree that an asset recognition model is necessarily required and that a FAS 5 approach should be rejected. (30) Since tax practitioners and most large companies do not currently consider audit detection risk in assessing their tax accruals, (31) we do not believe that a requirement presuming audit detection under FAS 5 will create significant issues. If the FASB is concerned that paragraph 38 ofFAS 5 requires rejection of the impairment approach, we recommend that the FASB modify FAS 5 as it applies to uncertain tax positions.
3. Initial Recognition--Dual Threshold Approach
The proposed Interpretation would permit an enterprise to recognize the financial statement effects of a tax position when the position is "probable" of being sustained by the enterprise following an audit by the taxing authorities. The proposed Interpretation explains that "the term 'probable' is used in the sense of paragraph 3(a) of FAS 5 to mean that 'the future event or events are likely to occur.'"
TEI disagrees with the dual-threshold approach and the "probable" recognition standard. TEI believes that a modified FAS 5 approach will lead to more reliable financial statements.
Alternatively, we urge the FASB to reconsider the approach recommended in paragraph B47 of the proposed Interpretation. In other words, the tax benefits of positions meeting the threshold under applicable tax law for the avoidance of penalties for underpayment of taxes should be recognized. Such benefits would be reduced by recording a liability for an amount representing the best estimate of payments (including interest) to taxing authorities. In the event the FASB believes that an asset recognition model should be adopted, the standard for initial recognition should in no event be higher than "more likely than not."
4. Subsequent Recognition
If a tax position did not previously meet the probable recognition standard, the proposed Interpretation would require the benefit to be recognized in a subsequent period where the threshold is satisfied.
TEI agrees that, under an asset-based model for recognition of tax benefits, a position that did not satisfy the initial recognition threshold (whether "probable" or some lesser standard) in a prior period should be recognized in a subsequent period in which the enterprise concludes that the recognition threshold has been met.
Under the proposed Interpretation, a previously recognized tax position that no longer meets the probable recognition threshold would be derecognized by recognizing an income tax liability or reducing a deferred tax asset in the period in which the enterprise concludes that it is more likely than not that the position will not be sustained on audit. An enterprise would not be permitted to employ a valuation allowance or account as a substitute for derecognition of the benefit of a tax position.
TEI agrees that under an asset recognition model a tax position should not be derecognized through a valuation allowance or account. We do not agree, however, that the potential disallowance of a tax position should be accounted for as though the tax position were never claimed. Specifically, under the proposed Interpretation, if a tax position (a) fails to satisfy the recognition threshold, (b) is claimed on a tax return, and (c) creates a realizable net operating loss carryforward, the enterprise would seemingly not be permitted to recognize the deferred tax asset of the net operating loss carryforward. As a result, users of the financial statement might be confused why an enterprise is not paying taxes in subsequent periods where the financial statements contain insufficient or no evidence of the net operating loss carryforward.
TEI recommends that the financial statements reflect the tax positions as reported on the tax return and account for the potential disallowance of those positions as a separate item, either as an impairment of the deferred tax asset or as additional taxes payable. In the example above, the enterprise would report a deferred tax asset for the net operating loss carryforward and separately report an impairment of the deferred tax asset, representing the potential disallowance of the net operating loss carryforward. When the net operating loss is utilized in future periods, the asset impairment accrual would be reduced, and an accrual would be recorded for taxes payable with respect to the tax period in which the net operating loss is utilized. TEI's recommendation will preserve the audit trail from the tax return to the financial statements and is consistent with the process through which the audit issues are resolved.
Under the proposed Interpretation, once the probable recognition threshold is satisfied, the best estimate of the amount that would be sustained on audit would be recognized. Paragraph 11 of the proposed Interpretation defines the best estimate as "the single most-likely amount in a range of possible estimated outcomes." Any subsequent changes in the recognized amount are also made using the best estimate method and recognized in the period of the change.
If an asset recognition model were adopted, TEI agrees that tax positions satisfying the initial recognition threshold should be recorded based on management's "best estimate" of the amount that is probable of being sustained on audit. We do not agree, however, with the proposed Interpretation's approach to the determination of the best estimate and recommend that it be modified substantially. In many cases, it is difficult to estimate one amount as the single best estimate. (32) FAS 5 accommodates such challenges by requiring an accrual at the low end of the range of loss and disclosure of the range. (33) When no amount within a range is a better estimate than any other amount within the range, the enterprise records the minimum benefit that is probable of being accepted. We recommend retention of an approach similar to current accounting principles, which requires a "reasonable estimate" of the loss incurred with respect to an uncertain tax position.
Finally, TEI also agrees that any subsequent changes in the amount of tax benefit recognized amount should be made using a best estimate methodology (modified as recommended by TEI).
Under the proposed Interpretation, the liability arising from the difference between the tax position and the amount recognized and measured under the proposed Interpretation would be classified as a current liability for amounts that are anticipated to be paid within one year or the operating cycle, if longer. Unless the liability arises from a taxable temporary difference, it would not be classified as a deferred tax liability.
TEI agrees conceptually with the proposed clarification that an accrued liability for a potential disallowance of a tax position should be classified as current or non-current based on the period in which the liability is expected to be paid. We have practical concerns, however, about an enterprise's ability to predict when tax audits will close and the effect of the timing of audit closings on the presentation of the financial statements. (34) Despite the best efforts of enterprises and taxing authorities to conclude examinations within stipulated time frames, unforeseen events frequently delay the closing of an examination and the payment of the liability. In order to minimize classification issues, we recommend that the FASB permit enterprises to classify their tax reserves as current liabilities. At a minimum, the proposed Interpretation should clarify the effect of the timing of closing of tax audits on the proper classification of a liability as well as the effect of delays in the closing of audits.
8. Change in Judgment
Under the proposed Interpretation, a change in the recognition, derecognition, or measurement of a tax position should be recognized entirely in the interim period in which a change in judgment occurs. The justification for the approach is that it is analogous to the effect of changes in tax rates under FAS 109.
TEI believes the proposed Interpretation's approach would produce interim financial statements that are highly volatile and thus potentially confusing for investors. We recommend retention of the current rules that require a taxpayer to estimate its effective tax rate and apply that rate consistently through the year (i.e., the "integral" approach of APB 28, which with two exceptions not relevant here was generally reaffirmed in FAS 109). (35) Under APB 28 and FAS 109, changes in judgment during the year are reflected by adjusting the rate for the balance of the year. Under the asset recognition approach of the proposed Interpretation, enterprises would in effect be required to compute quarterly tax returns for all material global tax jurisdictions in order to properly compute and report interim tax liabilities and reflect changes in judgment about uncertain tax positions. We do not believe the cost and complexity of such an exercise will improve the comparability, consistency, and reliability of financial statements. If there are concerns that the effect of tax settlements are not being reflected properly in the quarter in which such events occur, then more limited guidance addressing such matters should be issued.
9. Interest and Penalties
The proposed Interpretation would require enterprises to accrue interest on the difference between the tax benefit recognized in the financial statement and the tax return position in the period the interest is deemed incurred. Similarly, if a tax penalty would apply to the position, a liability for the penalty should be recognized. The proposed Interpretation provides no guidance on the classification of interest and penalties.
TEI agrees with the approach in the Proposed Interpretation and believes that there is no need to make other changes in the accounting for, classification of, or disclosure of interest and penalties related to potential tax deficiencies.
The proposed Interpretation would require loss contingencies relating to previously recognized tax positions be disclosed in accordance with paragraphs 9-11 of FAS 5. The proposed Interpretation also concludes that liabilities recognized in financial statements for tax positions that do not meet the probable recognition threshold are similar to contingent gains and should be disclosed pursuant to paragraph 17 of FAS 5.
TEI believes that the current disclosure requirements under FAS 5 for loss contingencies and contingent gains should be retained. Also, neither the dual recognition threshold nor the probable standard of the proposed Interpretation should be adopted. As important, we do not believe that previously recognized tax positions that fall below the probable standard should be derecognized and disclosed if the proposed Interpretation is adopted. If, contrary to our recommendations, the asset recognition model is adopted, the disclosure rules under FAS 5 might need to be reviewed for consistency with the asset recognition approach.
11. Effective Date and Transition Rule
The proposed Interpretation would be effective for fiscal periods ending after December 15, 2005. In addition, the proposed Interpretation would be applied upon adoption to all tax positions for which the statute of limitations remains open. Thus, only tax positions that satisfy the "probable" standard would be recognized or continue to be recognized. The cumulative effect of the change would be reflected as of the end of the period in which the Interpretation is adopted. In effect, any tax positions that do not satisfy the probable standard and have been previously recognized in an enterprise's financial statement would be derecognized.
For the reasons stated in our letter, TEI disagrees with the proposed effective date and the transition rule. Even if the FASB were to adopt the proposed Interpretation immediately upon the close of the comment period, enterprises would require more time to understand it, reevaluate all tax positions for all open tax years, review the effect of the adoption of the Interpretation with their audit firms, and document their tax positions and internal control procedures in compliance with section 404 of Sarbanes-Oxley. This will require substantial effort and time. Hence, the Interpretation should not be effective until the later of December 15, 2006, or six months following adoption.
Finally, we note that if the proposed Interpretation were adopted without change, the FASB should, at a minimum, clarify the effect of the transition rule on the uncertain tax positions of a previously acquired company. Specifically, if a previously acquired company's tax liabilities were to be increased (or assets decreased) because a tax position should be derecognized upon adoption of the Interpretation, the FASB should confirm that the charge on adoption of the Interpretation is to goodwill rather than to the income statement. We believe this recommendation is consistent with the intended results discussed in the comments section in Appendix C on the effect of the proposed Interpretation on EITF 93-7 and Question 17 of the Guide to Implementation of Statement 109 on Accounting for Income Taxes.
Miscellaneous Comments on Examples in Appendix A of the Proposed Interpretation
The examples set forth in Appendix A of the proposed Interpretation are helpful in understanding the proposed Interpretation. At the same time, they illustrate the complexity and ambiguity of applying the proposed Interpretation compared with the more straightforward analysis of the results that can be achieved under current accounting principles.
B. Research and Experimentation Credit Example and Unit of Account
The accounting result under the facts and circumstances discussed in paragraphs A2 through All of the proposed Interpretation would generally be the same under current accounting principles, but there is no need to determine the proper "unit of account," or engage in a complicated two-step analytical process to first document the technical merits of the position (validity) and then separately document the best estimate of the likely settlement of the position (valuation). The analysis is part of a single determination of a reasonable estimate of the amount of loss to be incurred with respect to the position.
The example is troubling because it implies that an enterprise must have prior audit experience from which it may assess the validity of each new research and experimentation project and determine the best estimate of the amount of tax benefit for each project. By definition, new research and experimentation projects will have elements that have never been reviewed by the taxing authorities. Hence, enterprises should be permitted to use their best judgment to determine the best estimate of the tax benefit.
In addition, no explanation is provided why each research project in the example constitutes a separate unit of account or how the enterprise determined the proper unit of account. The only guidance in the proposed Interpretation is that "[t]he appropriate unit of account may be different based on facts and circumstances." It is unclear why, for example, separate categories of research expenditures would not be considered the proper unit of account. Hence, even though the unit of account concept is seemingly intended to be a flexible tool for evaluating various tax positions, we believe it may lead to significant disputes and may not enhance financial accounting.
C. Temporary Differences and Validity and Value
For many uncertain tax positions, neither the validity nor the value of the tax benefit is in issue. Rather, the only dispute is the proper timing of the tax benefit. Under the proposed Interpretation, it is unclear whether a dispute about the proper timing of a tax benefit is an issue of "validity" or an issue of "value." For example, assume that in a business combination transaction an enterprise employs a questionable valuation assumption to reallocate $10 million of purchase price to short-lived assets from longer-lived assets for tax purposes. The potential reallocation of purchase price is seemingly a valuation issue. But the example in paragraphs A22 and A23 of the proposed Interpretation implies that the additional accelerated deductions attributable to the reallocation should be analyzed to determine the validity of the additional deductions. In addition, it is unclear whether the allocation of purchase price to short-lived assets must be treated as a separate "unit of account" for purposes of determining whether the issue is one of value or validity.
Finally, there are uncertain tax positions where the distinction between validity and value is unclear even when timing is not an issue. For example, if a taxing authority claims that an enterprise is not entitled to include certain tax items in the calculation of the base amount for a particular tax credit, does the disallowance of those tax items raise a question about the validity of the credit on those specific tax items, or is the dispute simply a question of the value of the credit that is allowable overall? Is this another circumstance where the enterprise must first determine whether the additional tax items are a separate "unit of account" before analyzing the validity and value issues? The proper application of the proposed Interpretation in this relatively common situation is highly uncertain and underscores why current accounting principles can be applied with better results and greater reliability than the proposed Interpretation.
D. Transfer Pricing Example
The accounting result under the circumstances discussed in paragraphs A16 through A21 of the exposure draft is generally the same under current accounting principles, but the result is more easily explained under current principles. Since the enterprise has documented that its transfer-pricing methods are reasonable and supportable, the enterprise would conclude under current rules that it is not probable that the taxing authorities would assert a transfer-pricing adjustment.
Although the example is helpful and provides assurance that enterprises do not have to assume transfer-pricing adjustments will be made simply because of the inherent complexity and ambiguity of the rules, application of the example's principles to more complex but common transfer-pricing facts and circumstances will lead to significant confusion. For example, if an intercompany transaction is challenged by the taxing authority on the basis that a payment is considered a nondeductible contribution to capital and the enterprise's position that the payment is fully deductible does not satisfy the probable threshold for initial recognition, no benefit would be realized. This would be the result even where the enterprise can establish that its treatment of the transaction is "more likely than not" correct and that the matter can be resolved by a concession of no more than 40 percent of the tax benefit. Under current accounting principles, the enterprise would recognize the tax benefit of the reported tax treatment and then record a loss contingency accrual for the reasonable estimate of the amount that would be incurred to resolve the matter.
E. Amortization Example
The example assumes--perhaps unrealistically--that 15-year amortization is the treatment that is probable of being sustained. A more likely outcome is that, because of uncertainty in the applicable tax rules, there is a 40-percent to 60-percent chance that the deduction will be sustained, and a 40-percent to 60-percent probability that 15-year amortization will be sustained. In such circumstances, is it accurate to say that 15-year amortization is the treatment that is probable of being sustained?
As another example, assume that the taxpayer deducts the entire amount of transaction costs and the taxing authority's primary position is that no amortization is allowed (i.e., permanent capitalization). The taxing authority's alternative position is that 15-year amortization is permitted. If each of the outcomes (full deduction, permanent capitalization, or 15-year amortization) is equally probable of being sustained, what amount should be recognized initially or derecognized upon disallowance of the taxpayer's immediate deduction? Must the enterprise record its tax benefits based on the least favorable outcome unless it can prove that a more favorable outcome is probable of being sustained?
Where multiple resolutions are possible with differing levels of uncertainty for each resolution, current accounting principles will more easily permit an evaluation of a reasonable estimate of the expected settlement. This evaluation, although complex from a tax perspective, is relatively straightforward and conforms with current commercial practices in assessing the outcome of tax controversies.
(1) Statement of Financial Accounting Standards 109, Accounting for Income Taxes (1992).
(2) Proposed Interpretation, paragraph B46.
(3) Statement of Financial Accounting Standards No. 5, Accounting for Contingencies (1975).
(4) With the recent federal (and, in many cases, state) tax law changes requiring enhanced tax return disclosures (e.g., required disclosures for "listed" or "confidential" transactions, loss transactions in excess of $10 million, and book and tax accounting differences in excess of $10 million on Schedule M-3 of Form 1120) as well as the enhanced penalty provisions enacted in the 2004 tax act, the probability of audit detection for material federal (and likely state) income tax transactions is high.
(5) For example, if a tax position is not examined during an audit and the audit is closed without a change to the item, it is unlikely the tax position will be reviewed again even though a subsequent review is not legally precluded.
(6) For example, assume an enterprise deducts $10 million for environmental cleanup costs, which the enterprise concludes will more likely than not be sustained on audit and which yields a $3.5 million tax benefit. If the enterprise cannot satisfy the "probable" level of confidence for the deduction, the proposed Interpretation would require a liability to be accrued for the entire $3.5 million. We believe this produces a patently misleading financial statement when it is more likely than not that a substantial portion of the costs will be allowed as a deduction (even if the enterprise cannot satisfy a probable level of confidence for the entire $10 million).
(7) Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements (1985).
(8) For example, it may be appropriate to (1) recognize no benefit from a listed transaction (even where the company obtains a should-prevail opinion), (2) fully or partially reserve a tax position where the principal purpose of the position is the avoidance of tax, or (3) fully recognize a position arising in the ordinary course of business that is supported only by a more-likely-than-not level of confidence. The foregoing standards may not be wholly congruent, but the objective in each case is to reflect a reasonable estimate of the expected liability.
(9) For example, assume an enterprise has 10 research projects that it believes will more likely than not qualify for the research credit. Each project has a potential credit value of $100. Under current accounting principles, the enterprise would likely conclude that a net tax benefit of between $450 and $550 of tax benefit will likely be sustained and accordingly should be recognized. (Properly speaking, a benefit of $1,000 would be recognized and a contingent loss accrual of $450 to $550 would also be recorded.) Under the proposed Interpretation, since no individual project satisfies a "probable" level of confidence of being sustained, the enterprise would record no benefit. The artificial two-step process of first determining the validity of a project under the probable standard and then recognizing the value of only the items that satisfy the standard will lead to consistent overstatement of liabilities in years when the project expenditures are incurred. In subsequent years when the matters are resolved or the statute of limitations expires, the enterprise's reported tax expense will likely be substantially less than the actual cash outflow and liability for the year.
(10) See paragraph 7 of the proposed Interpretation and the explanation in paragraphs B12 through B16.
(11) Under U.S. tax principles, a reasonable basis standard is generally less than substantial authority.
(12) With respect to tax positions that are not reflected on a tax return or information return (e.g., a position that a tax return is not required to be filed because the enterprise is not subject to tax in a particular jurisdiction), the presumption should not apply and those matters should be evaluated under the general standard (i.e., whether it is probable that a claim will be asserted).
(13) Proposed Interpretation, paragraph 6.
(14) See FASB Special Report, Application of FASB Statements 5 and 114 to a Loan Portfolio (1993), Q.8.
(15) Should-prevail opinions are rarely given by practitioners, especially in respect of fact-intensive tax issues such as capitalization, transfer pricing, or the qualification of expenditures for the research and experimentation tax credit. Moreover, because of the cost of obtaining should opinions, enterprises generally seek them only for the largest and most complex transactions.
(16) Although there is an abundance of litigation over U.S. federal tax laws, there are far fewer reported cases from state and foreign litigation. Hence, enterprises will have far more difficulty satisfying a "probable" standard in respect of their uncertain state and foreign tax positions.
(17) TEI is not persuaded that the proposed Interpretation will improve consistency and comparability in financial statements. The primary source of "inconsistency" in the recognition of tax benefits is the application of nebulous tax laws to myriad facts and circumstances.
(18) CON 6, footnote 18, states: "Probable is used with its usual general meaning, rather than in a specific accounting or technical sense (such as that in FASB Statement No. 5, Accounting for Contingencies, par. 3), and refers to that which can reasonably be expected or believed on the basis of available evidence or logic but is neither certain nor proved (Webster's New World Dictionary of the American Language, 2d College ed. [New York Simon and Schuster 1982], p. 1132). Its inclusion in the definition is intended to acknowledge that business and other economic activities occur in an environment characterized by uncertainty in which few outcomes are certain (pars. 44-48)."
(19) The consideration of non-technical issues, such as whether a proper business purpose exists for a transaction, may lessen confidence in whether a position can be sustained. Failure to consider such issues would almost certainly diminish the reliability of the financial statements.
(20) For example, U.S. federal tax law does not formally sanction a de minimis threshold for capitalization of expenditures. Nonetheless, nearly every company has reached an accommodation with the IRS that expenditures below a threshold amount will not be reviewed. Hence, the taxpayers effectively obtain a deduction for de minimis fixed asset amounts. TEI submits the reliability of financial statements would be diminished if informal administrative practices that focus taxpayer compliance and tax authority examination resources on material issues were ignored.
(21) See paragraph B47 of the explanation of the proposed Interpretation for the views expressed by some Board members.
(22) Recent amendments to the Internal Revenue Code would require a more likely than not threshold for certain transactions.
(23) The proposed Interpretation would apply to temporary as well as permanent tax differences. The benefit to financial statements of applying the probable standard to tax positions where the only uncertainty is the "timing" of the realization of a tax benefit from a temporary difference is attenuated. On the other hand, the time and effort to document and account for the difference between the tax benefit in the return and in the financial statement for temporary tax differences is substantial. As a result, if the asset recognition model is adopted, the FASB should consider applying it only to permanent items.
(24) TEI anticipates that adjustments to conform to the best estimate measurement rule would be minimal because that rule is not significantly different from the reasonable estimate measurement rule under FAS 5.
(25) The proposed Interpretation's December 15, 2005, effective date is seemingly premised on the assumption that enterprises need only complete an assessment of their most recently filed federal and state tax returns in order to compute the effect of adoption. See paragraph B41. That assumption understates the effect in the change in the recognition threshold for all prior years' tax positions as well as the requirement to document and test changes to the enterprises' internal controls under Sarbanes-Oxley.
(26) Statement of Financial Accounting Standards No. 123 (revised), Share-Based Payment (2004).
(27) Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (1992).
(28) A Guide to Implementation of Statement 109 on Accounting for Income Taxes: Questions and Answers (1992), Q&A 17.
(29) The proposed Interpretation was conceived to address "uncertain" tax positions, i.e., tax-motivated transactions with a questionable legal support. One means of restricting the scope of the proposed Interpretation to its initial target (and thereby limit the burden of compliance to its original purposes) would be to apply the standard solely to "listed" transactions as defined for U.S. federal tax purposes. That formulation, however, would not address tax-motivated state or foreign transactions.
(30) The standards of tax practice issued by the U.S. Treasury Department and Internal Revenue Service preclude tax practitioners from considering the risk of audit detection when rendering tax opinions. See Circular 230, Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries, and Appraisers before the Internal Revenue Service, 31 C.F.R 10 (June 20, 2005).
(31) Even before the recent amendment of Circular 230, few practitioners considered the risk of audit detection when assessing the likely success of a tax position since doing so would generally have voided the penalty protection that the opinion might have afforded.
(32) For example, assume that a tax benefit for a position ranges from $50 to $100 and that there is a 20-percent likelihood each of resolving the uncertainty for $60, $70, $80, $90, and $100. How much benefit should the taxpayer recognize in such a situation? We do not believe an answer can be determined from the proposed Interpretation. There are numerous issues where the expected value of the settlement positions will have a wide variance and non-normal distribution. In other words, the proposed Interpretation's best estimate model will work in some cases where the expected value of settlement probabilities approximates a normal bell-shaped distribution, but it does not work at all for other expected value probability distributions (e.g., a U-shaped expected value probability). Under a probability-weighted "expected amount" approach of CON 7, the answer to the simple fact pattern above is $80, being the sum of the expected values of $12, $14, $16, $18, and $20. TEI does not, however, support an expected-value approach to measurement of tax benefits because it would be highly complex and imply a level of precision in the financial statements that rarely exists in the settlement of tax disputes.
(33) FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss, an interpretation of FASB Statement No. 5 (1976).
(34) Assume, for example, that a taxpayer believes it likely that an examination will close in the coming year and classifies a potential liability as current. During the year, it becomes clear that the examination will not close and may not close within the following year. If the enterprise reclassifies the liability from current to non-current, should the reclassification be considered a change in estimate or an error? Would the enterprise be required to restate its prior year comparative balance sheet in order to be comparable?
(35) Accounting Principles Board Opinion No. 28, Interim Financial Reporting (1973).
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