FIN 48

Accounting for uncertain tax positions

Earlier this year the Financial Accounting Standards Board (FASB) in the US released an Interpretation (FIN 48) with the goal, through the use of consistent criteria, of reducing diversity in approaches to recognising, measuring and presenting income taxes for uncertain tax positions under US GAAP. This bulletin gives an overview of the Interpretation and highlights some of the issues it raises for companies. Background

December 2006

FIN 48 is almost certainly amongst the most significant tax developments in a number of years. It has significant practical and technical consequences and a relatively small implementation window for affected companies. Organisations affected by FIN 48 will need to consider the adequacy of their processes for identifying and monitoring their uncertain tax positions, their approach to provisioning and the increased attention to certain tax positions which may result from the increased disclosure and transparency.

Determining the recognition of associated tax benefits Measurement of those tax benefits

Identifying uncertain tax positions

The Interpretation applies to all tax positions related to income taxes subject to FAS 109. The term refers to any position in a previously filed tax return or reflected in the current or deferred taxes in interim or final accounts. It can include: A decision not to file a tax return An allocation of income between jurisdictions The decision to exclude reposting taxable income in a tax return A decision to classify a transaction, entity, or other position in a tax return as tax exempt. Whilst FIN 48 applies to all tax positions, the key focus will be on significant exposures where there is uncertainty as to the outcome. Organisations will, therefore, need to be able to identify all of those tax positions requiring consideration under FIN 48.

Who does it affect?

FIN 48 affects all entities preparing accounts in accordance with US GAAP. It applies for accounting periods commencing after the 15 December 2006. Consequently, it will affect foreign SEC registrants as they will be required to apply the recognition and measurement guidance in FIN 48 in preparing their SEC reporting. Under SAB 74 all SEC entities will have to disclose, in their next SEC filing, the impact that the Interpretation will have on financial statements when it is adopted in the future. For many organisations, at this early stage, it may not yet be possible to quantify the impact of FIN 48. The FASB, does however, anticipate that by early 2007 organisations will have had sufficient time to determine the impact on their business.

Recognition
In order for a tax benefit arising from a tax position to be recognised it has to have a more likely than not chance of being accepted on its technical merits by the relevant taxing authority. A unit of account is the level at which the more likely than not question is assessed for a particular tax position. Determining the unit of account will be based on a judgment of the facts and circumstances of the tax position. The Interpretation says the judgment should be based on a consideration of the manner in which the enterprise prepares and supports its tax return and the approach that the tax

How does it work?

FIN 48 essentially follows three steps in establishing the tax benefits to be recognised in the accounts: Identifying tax positions

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authorities will take when examining the tax return. So to take the example from the Interpretation, for a number of large projects the unit of account may be the projects individually or the functional expenditure lines across all projects. Once the unit of account has been identified, the more likely than not assessment is made based on: The technical merits of the tax position The applicability to the facts and circumstances The practices and precedents of the tax authorities This assessment is made without consideration of the possibility of offset or aggregation with other tax positions, and there is a presumption that the tax authorities have full knowledge of all relevant information.

settlement and has good experience of the likely level of settlement based on its experience with respect to similar tax positions. There are certain kinds of transactions where the revenue authorities will always litigate, which currently appears to be the case in the UK in certain scenarios, and this would imply that, where the more likely than not threshold has been passed, no provision would be appropriate. Where tax planning has been entered into with a view to generating a source of income to support a deferred tax asset, FIN 48 applies in the same way to determine the amount of future available taxable income.

Interest and penalties

The Interpretation states that a benefit claimed in a tax return but not recognised in the financial statements effectively represents a position on which interest should be accrued and potential penalties provided if applicable.

Measurement
Once it has been determined that a position meets the more likely than not threshold, the next step is to determine the amount of tax benefit that can be recognised. Under FIN 48 this is the largest amount of tax benefit that has a more than 50% chance of being realised on ultimate settlement. This is best understood by an example: A company takes a deduction in a tax return that results in a tax benefit of a 100. It assesses its likelihood of settling at various levels as follows. Amount of tax % likelihood the Cumulative benefit tax position will probability the expected to be be sustained at tax position will sustained this level be sustained 100 30% 30% 80 60 30 20 10% 15% 25% 20% 40% 55% 80% 100%

Disclosure
Financial statement classification The above analysis will result in either a FIN 48 tax liability or a reduction in a deferred tax asset. The FIN 48 tax liability will not be a deferred tax and must be separately classified from other tax balances. Interest can be classified as tax or interest, and penalties as tax or other expenses; subject to an accounting policy election by the enterprise. The election must be applied consistently. Disclosure notes The Interpretation requires a significant amount of disclosure: Tabular roll-forward of aggregated unrecognised tax benefits The total amount of unrecognised tax benefits that, if recognised, would affect the effective tax rate The total amount of interest and penalties recognised in the income statement and accrued on the balance sheet Discussion of reasonably possible changes in unrecognised tax benefits in the next 12 months Description of open tax years by major jurisdictions.

The highest benefit which has a greater than 50% chance of being sustained if 60, so this is the benefit to be recognised under FIN 48 for this tax position. Such a table may be necessary where there are a number of possible outcomes. In many situations, where for example the options are win, lose or settle, there may be just a single amount that is perceived to be more than 50% likely. This could be the case where the organisation is confident it will negotiate a

The impact of this level of disclosure is considered below.

Implications
Increased levels of disclosure Putting the practical considerations to one side, the issue that has given rise to some of the most immediate concern has been the level of disclosure and its impact on the ultimate outcome of negotiations with tax authorities. In many jurisdictions, such as the UK and the US, there is no automatic right of access to details of the numbers in the tax provision, either as a consequence of specific protection or because the information is not relevant to the tax analysis. Nevertheless, there is a concern that in certain countries the tax authorities may react to a local disclosure by becoming (considerably) more assertive. This might particularly be the case where the disclosure describes whether settlement with the tax authorities within the next 12 months is reasonably possible. In cases where the provision is in the parent, for example in the US, it may also be the case that a local tax authority may attempt to obtain details by exchanging information. This process is far from straightforward and its success depends on the circumstances and the jurisdictions involved. Tax advantaged finance transactions An issue requiring consideration is the impact of FIN 48 on the approach to provisioning for tax advantaged transactions. FIN 48 starts from the perspective of a unit of account. Therefore, it will be important to determine what this is for these kinds of transactions. Given that they are often technically complex, may involve a number of entities, or be cross-border, determination of the unit account may be very challenging and require careful consideration. Once the unit of account has been identified, the more likely than not analysis is made (without any offset or aggregation with other positions). The subsequent valuation of benefits to be recognised is assessed at the unit of account level and as such has to look at the possibilities on ultimate settlement of that tax position. Permanent establishments A tax position includes the decision not to file a tax return. This will mean enterprises will have to consider potential permanent establishment (or attribution) risk, in countries

in which they operate. Where there is a problem in passing the more likely than not threshold, determining the FIN 48 tax liability will require the enterprise to look at all open years and assess the total potential tax liability. Where there is no statute of limitations for unfilled tax returns, which is the case for US state taxes, this could result in FIN 48 liabilities that never reverse and interest accruing in perpetuity. If the jurisdiction has a widely understood administrative practice of only pursuing back-taxes for a clearly defined number of years, companies could take this into account in the measurement of the tax benefit. In practice this assessment could be far from easy as what is widely understood may not be particularly easy to determine.
Transfer pricing

For many organisations their most significant uncertain tax position will be in relation to their transfer pricing. FIN 48 will require a potentially large amount of work in identifying all relevant positions and carrying out the recognition and measurement assessment. Even where ultimately the impact of corresponding adjustments can be taken into account the assessment will nonetheless need to be made in order to establish that there is not a material uncertain tax position overall. Subsequent change Once the benefit of a tax position has been recognised the assessment cannot then be changed unless: The tax is settled by negotiation or litigation. The statute of limitations in respect of a tax position has expired, or There is a change in the more likely than not analysis. With respect to the latter, this can only come about through a change in the facts (e.g. a resolution of a relevant court case) but not a new evaluation or interpretation of the existing facts (maybe a new Counsels opinion based on the same legal position but drawing a different conclusion). The same applies to the measurement of the tax benefit, i.e. the measurement can only be changes for new facts, such as settlements of other taxpayers, court cases, rulings etc.

What should you be doing?

Management should consider: Whether the company has the necessary resource and information collection and management processes to implement and comply with FIN 48 in a timely manner. The strength of tax related internal controls and whether they need to be developed to take the Interpretation into account. Current tax policies and disclosure and the extent of the change required to enable adoption. The impact of adoption on key financial measures and what communication may be needed with relevant stakeholders (analysts or shareholders for example). Whether there is any process that might usefully be considered to expedite the resolution of open issues.

Contacts
Andrew Wiggins Jeremy Curd Andrew Bancroft 0121 232 2065 020 721 35208 0121 232 2059 andrew.wiggins@uk.pwc.com jeremy.k.curd@uk.pwc.com andrew.bancroft@uk.pwc.com

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