WW May 2006 - Audit, Tax, Corporate & Risk Advisory · through corporate income tax planning. In...
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It is entirely normal for businesses to seek to reduce their tax burdens and either minimize or defer cash outflows for income taxes, causing almost all business tax returns to include positions that may be subject to significant and varied interpretations – from domestic and foreign income allocations arrangements to transfer pricing between affiliates and others. These positions often result in uncertainties about whether tax filing positions will ultimately pass the review of the relevant taxing authorities -- which may occur several years after the tax returns are filed. To address this issue, in July 2006, the Financial Accounting Standards Board (FASB) released FASB Interpretation No. 48 (FIN 48) “Accounting for Uncertainty in Income Taxes,” which was intended to reduce the substantial diversity in accounting for tax uncertainties that has developed as both public and private com- panies evaluate, for financial reporting purposes, the likelihood that the benefits of these tax positions will be upheld. These varied interpretations came about because FASB Statement No. 109 “Accounting for Income Taxes,” contains no specific guidance on how to address uncertainty in accounting for income “tax assets and liabilities. The key concern is the proper presen- tation of these income tax assets and liabilities for financial statement purposes. FIN 48 generally applies to all U.S. Federal, State and local income tax positions and foreign tax positions. The Key Points in FIN 48 Include ■ A tax benefit may only be reflected in the financial state- ments if it is “more likely than not” (more than 50% likeli- hood) that the company will be able to sustain the tax return position upon examination, based on its technical merits and assuming full disclosure of the facts. The “more likely than not” test is a substantially greater hurdle than the former “reasonableness” test. ■ A tax benefit should be measured as the largest amount of ben- efit that is cumulatively greater than 50% likely to be realized ■ Additional disclosures, including positions expected by manage- ment to change significantly within the next 12 months as well as the quantitative roll forward of the worldwide aggregated amount of unrecognized tax benefits ■ Tax positions must be evaluated at each balance sheet date In January 2007, the FASB confirmed the implementation date of FIN 48 for accounting periods starting after December 15, 2006 (e.g., January 1, 2007 for calendar year entities); for many businesses, particularly those with either an international parent or international subsidiaries, this significant tax accounting development has both far-reaching implications and a small window of time for implementation for businesses affected by this ruling to ensure that their financial statements reflect expected past and future tax consequences of uncertain tax posi- tions. This interpretation applies to all entities that report in accordance with GAAP, including public and private companies, not-for-profit organizations, pass through entities (such as part- nerships) and certain real estate investment structures and requires a higher standard of accruing a tax benefit in financial statements than the IRS imposes on tax returns to avoid a penalty. Because of the implementation of FIN 48, the external auditor is now potentially placed in the key central role of reviewing and overseeing that the benefits of the tax positions reflected in the financial statement will “more likely than not” be sustained, World Watch The newsletter for the international community August 2007 FIN 48 Effectively Puts External Auditors in the Position of Agents of the Internal Revenue Service
Transcript of WW May 2006 - Audit, Tax, Corporate & Risk Advisory · through corporate income tax planning. In...
It is entirely normal for businesses to seek to reduce their
tax burdens and either minimize or defer cash outflows for
income taxes, causing almost all business tax returns to include
positions that may be subject to significant and varied
interpretations – from domestic and foreign income allocations
arrangements to transfer pricing between affiliates and others.
These positions often result in uncertainties about whether tax
filing positions will ultimately pass the review of the relevant
taxing authorities -- which may occur several years after the tax
returns are filed.
To address this issue, in July 2006, the Financial AccountingStandards Board (FASB) released FASB Interpretation No. 48 (FIN48) “Accounting for Uncertainty in Income Taxes,” which wasintended to reduce the substantial diversity in accounting for taxuncertainties that has developed as both public and private com-panies evaluate, for financial reporting purposes, the likelihoodthat the benefits of these tax positions will be upheld. These varied interpretations came about because FASB Statement No. 109 “Accounting for Income Taxes,” contains no specific guidance on how to address uncertainty in accounting for income“tax assets and liabilities. The key concern is the proper presen-tation of these income tax assets and liabilities for financialstatement purposes. FIN 48 generally applies to all U.S. Federal,State and local income tax positions and foreign tax positions.
The Key Points in FIN 48 Include
n A tax benefit may only be reflected in the financial state-ments if it is “more likely than not” (more than 50% likeli-hood) that the company will be able to sustain the tax returnposition upon examination, based on its technical merits and
assuming full disclosure of the facts. The “more likely thannot” test is a substantially greater hurdle than the former“reasonableness” test.
n A tax benefit should be measured as the largest amount of ben-efit that is cumulatively greater than 50% likely to be realized
n Additional disclosures, including positions expected by manage-ment to change significantly within the next 12 months as wellas the quantitative roll forward of the worldwide aggregatedamount of unrecognized tax benefits
n Tax positions must be evaluated at each balance sheet date
In January 2007, the FASB confirmed the implementation date of FIN 48 for accounting periods starting after December 15, 2006(e.g., January 1, 2007 for calendar year entities); for many businesses, particularly those with either an international parentor international subsidiaries, this significant tax accountingdevelopment has both far-reaching implications and a small window of time for implementation for businesses affected bythis ruling to ensure that their financial statements reflectexpected past and future tax consequences of uncertain tax posi-tions. This interpretation applies to all entities that report inaccordance with GAAP, including public and private companies,not-for-profit organizations, pass through entities (such as part-nerships) and certain real estate investment structures andrequires a higher standard of accruing a tax benefit in financialstatements than the IRS imposes on tax returns to avoid a penalty.
Because of the implementation of FIN 48, the external auditor isnow potentially placed in the key central role of reviewing andoverseeing that the benefits of the tax positions reflected in thefinancial statement will “more likely than not” be sustained,
WorldWatchThe newsletter for the international community
August 2007
FIN 48 Effectively Puts External Auditors in thePosition of Agents of the Internal Revenue Service
based on their technical merits and assuming full disclosure of thefacts. This places the auditor in the new role of “agent” of the IRS.
For tax years beginning after December 15, 2006, the tax accrual mayonly contain positions that meet the “more likely than not” standard,and any variances must be disclosed in the financial statements. Thiscreates more work for the auditor on the tax accrual because evencommon issues like unreasonable compensation or expensing versuscapitalization now need to be evaluated. The result is that the posi-tions taken on the return (orthat were taken in any year notclosed by the statute of limita-tions) which do not meet the“more likely than not” standardwill have to be disclosed andwill likely be subject toincreased IRS scrutiny.
In this regard, particular atten-tion should also be paid to thetransfer pricing between relatedentities for products and/or serv-ices (Please see our December2006 World Watch regarding "TheDetermination of Arm's LengthPricing"). By altering thesecharges, income can be shiftedfrom one jurisdiction to another,thereby resulting in a potentialunderstatement of income taxes.Moreover, this could occur andmay need to be considered bythe external auditor in some less than obvious situations when address-ing the requirements of FIN 48. For example, a foreign subsidiary whichsupplies products has a net operating loss and therefore the companylogically assumes that no income tax liability needs to be provided. Onthe surface, this appears correct, but what if that loss was createdbecause the price charged was inadequate? A different result, perhaps.Irrespective of whether examined internally by company managementor externally by third parties, this should not be overlooked.
Transfer pricing studies are now, more than ever, an invaluable toolthat management should use to determine arm’s length pricingbetween related parties. Under Section 482 of the Internal RevenueCode and applicable penalty sections, there are no discussions of thelevel of opinion needed in these studies. The old “reasonableness”
test and the FIN 48 test of “more likely than not” have to be inter-preted by the company and ultimately by the company’s externalauditor.
For many entities, their most uncertain tax positions may be in relation to their transfer pricing policies.
In dealing with a company with material related party transactions,the external auditor will have to pay heavy attention to the company’s
transfer pricing study.
For calendar year corporations, thenew rules would initially take effectwith first quarter 2007 results.However, the new rules require calendar year corporations to have a “clean” starting point for their taxreturns as of January 1, 2007. Inother words, the deferred tax assetand deferred tax liability accounts on that date must be determined in accordance with the standards of FIN 48.
Evaluation Is a Two-StepProcess
The evaluation of a tax position inaccordance with FIN 48 is a two-stepprocess. The first step is recognition:Companies must determine whetherit is more likely than not that their
tax positions will be upheld upon examination, including resolution ofany related appeal or litigation processes, based on the technical mer-its of the position.
The second step is measurement: Tax positions that meet the “morelikely than not” recognition threshold are measured to determine theamount of benefit to recognize in the financial statements. The taxposition is measured at the largest amount of benefit that is greaterthan 50% likely of being realized upon ultimate settlement.
Points to Consider
Companies should be concerned about FIN 48 because there is nowgreater disclosure to the tax authorities on what companies believe aregoing to be the likely outcomes of certain tax positions, potentially
Continued on page 4
“ …we recommend that a company’s financial managementand tax departmentteams educate themselves immediatelyon the requirements of FIN 48…”
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increasing the difficulty of reaching settle-ments. These disclosures may also detercompanies from seeking to reduce theiroverall tax burden or delay cash outflowsthrough corporate income tax planning.
In the new tax world of FIN 48, the challenges faced by many company management teams are
n Whether the company has the neces-sary resources, information collection and management processesin place to implement and comply withFIN 48 in a timely manner
n The strength and depth of their tax-related internal controls and whetherthey need to be developed further toimplement and adhere to the newrequirements
n Comparison of current tax policies anddisclosure processes and how theseexisting protocols stand-up to the newrequirements
n Quantification of the impact of adop-tion on key financial measures andwhat communications will be neces-sary with relevant stakeholders, suchas shareholders or analysts
n What action steps should be devel-oped to expedite the resolution ofopen issues
A Plan of Action
First, we recommend that a company’sfinancial management and tax departmentteams educate themselves immediately onthe requirements of FIN 48 and its potentialeffects on the day-to-day business opera-
tions of the company. These requirementsmay include income statement volatility,increased transparency regarding tax positions and increased inquiries fromstakeholders and other parties as well as potential increased compliance costs. At the same time, the team should assessits available in-house resources, specificallywho will be charged with driving the FIN 48adoption and compliance process.
Second, we recommend that companiesidentify all tax positions or potential taxpositions that need to be evaluated, assesseach identified position and then determinethe recognition and measurement obliga-tions. We also recommend that public companies issue relevant Form 10-Q disclosures for the quarter of adoption andalso consider disclosures required to beincluded in previous Form 10-Qs or 10-Ks. A review of Sarbanes-Oxley Section 404may also be necessary to determine allrequired disclosures.
Conclusion
The result of FIN 48 will be increased rele-vance and comparability in financial report-ing of income taxes because all tax posi-tions accounted for in accordance withStatement 109 will be evaluated for recogni-tion, derecognition and measurement usingconsistent criteria with reduced flexibility.The company and its management must beeducated and ready as both the company’sexternal auditors and the IRS will have tobe satisfied.
If you have any questions or would like tolearn more about FIN 48 and its impact onyour financial statements, please contactour professionals at RSM McGladrey. n
