Client Alert

Executives who oversee the preparation of their organizations' financial statements are currently in the thick of dealing with substantial new responsibilities regarding accounting for income taxes--responsibilities imposed by the Financial Accounting Standards Board ("FASB") on July 13th, 2006. On that date, FASB posted to its website the final version of FASB Interpretation No. 48 (Accounting for Uncertainty in Income Taxes -- an Interpretation of FASB Statement No. 109) (hereinafter “FIN 48”). As most accounting professionals now know, FIN 48 contains a complex set of rules on when and how income tax positions that may be subject to challenge by relevant taxing authorities (“uncertain income tax positions”) should be recognized for financial accounting purposes. The rules under FIN 48 generally are effective for fiscal years beginning after December 15, 2006 despite attempts during the last half of 2006 by hundreds of companies and several trade and lobbying groups to persuade FASB to defer that effective date.

FASB’s stated reason for issuing FIN 48 was that, prior to its issuance, enterprises had no specific guidance on how to recognize uncertainty in accounting for income tax assets and liabilities. Consequently, differing practices had developed to determine whether and how tax benefits would be recognized in financial statements. This diversity in practice, according to FASB, resulted in “noncomparability” in reporting income tax assets and liabilities; FIN 48 is an attempt to provide consistent accounting practices and criteria to ascertain reportable benefits arising from uncertain income tax positions.

Enterprises subject to the rules under FIN 48 include public and private for-profit businesses, not-for-profit organizations, pass-through entities, and entities whose tax liability is subject to reduction for dividends paid (such as REITs and RICs). While FIN 48 applies to all federal, state, local and foreign income tax positions, it does not apply to sales, value-added or property taxes.

A "tax position" for purposes of FIN 48 includes both a position in a previously filed tax return for a tax year that is still open for audit, and a position that is expected to be taken in a future tax return, but that is reflected in measuring current or deferred income tax assets and liabilities for interim or annual periods. A "tax position" also includes a decision not to file a tax return, an allocation or shift of income between jurisdictions, the characterization of income, a decision to exclude reporting taxable income in a tax return, and a decision to classify a transaction or entity in a tax return as tax exempt. Entities subject to FIN 48 must consider each and every tax position separately, including in theory positions previously thought non-controversial. However, the appropriate unit of account for determining what constitutes an individual tax position is left to the subjective judgment of each entity (and its advisors) based on the specific facts and circumstances of that position.

Compliance with FIN 48 requires organizations to apply a two-step analysis. First, for each income tax position, the entity must evaluate whether it is more likely than not that such position will be sustained upon examination. While the concept of “more likely than not” is defined to mean a likelihood of more than 50 percent, here again FIN 48 entrusts each enterprise (and its tax advisors) to subjectively determine whether a particular tax position in fact meets this standard based on the specific facts, circumstances, and information available at the date of reporting. Tax positions that do not meet the more-likely-than-not standard may not be recognized on the entity’s current financial statements.

In assessing whether any particular tax position satisfies the more-likely-than-not test, organizations are directed to assume that the tax position will be examined by each relevant taxing authority, and that each such taxing authority will have full knowledge of all relevant information. When past administrative practices or precedents of a taxing authority relative to a tax position are widely understood, enterprises are further directed to take into account such practices and/or precedents. For example, if a corporation has not filed tax returns in two states that may assert "nexus," the statute of limitations in those states may be open for all years. However, if one of those states follows a widely understood administrative practice of not asserting liability for more than six years, then the corporation need only consider potential tax liability to that state for the most recent six years. Finally, entities may not consider the possibility of offset or aggregation with other positions when evaluating whether a particular tax position satisfies the more-likely-than-not standard.

For each tax position that meets the more-likely-than-not threshold, entities must next measure the amount of tax benefits that can be recognized for financial accounting purposes. In general, the amount to be recognized is the largest amount of tax benefits that is greater than 50 percent and that is likely to be realized upon ultimate settlement with each of the relevant taxing authorities having full knowledge of all facts relevant to the tax position. Ultimate settlement apparently includes a closing agreement with the taxing authority and a final, non-appealable judicial decision that addresses the income tax position.

Application of FIN 48 necessarily will highlight differences between the amount of tax benefits recognized in an enterprise’s financial statements and the amount taken or expected to be taken in a tax return for the current year. Differences between tax positions taken in a tax return and amounts recognized in financial statements will generally result in an organization’s financial statements disclosing (i) an increase in a liability for income taxes payable or a reduction of an income tax refund receivable, (ii) a reduction in a deferred tax asset or an increase in a deferred tax liability or (iii) both. Moreover, the entity must also record in its financial statements a liability for interest and potentially penalties that would be due taxing authorities based on the difference between the amount of tax benefits recognized on the enterprise’s tax returns and the amount reflected in its financial statements.

Now, an IRS revenue agent or a field agent for a state taxing authority need only review an entity’s financial statements to determine what tax positions the entity believed were uncertain and the degree of confidence (or lack thereof) the entity had in those tax positions given the dictates of FIN 48. In addition, the IRS has historically followed a policy of restraint with regard to requesting tax accrual workpapers during the course of an audit. However, various IRS officials in recent months have announced that they are reconsidering this policy in light of FIN 48. While the IRS might not change its policy, companies should nonetheless exercise caution in preparing those workpapers and related supporting materials. Consideration should be given to whether advice regarding tax matters supporting the tax accrual workpapers can be handled in a manner such that the attorney-client privilege can be available to protect access to that information.

Because FIN 48 requires financial statement issuers to analyze their entire inventory of tax positions in every jurisdiction, for every taxing authority, and for every open tax year, competent advice on whether a tax position is “uncertain” and whether that position can satisfy the "more-likely-than-not" test will become critical in order to comply with FIN 48. For example, a business entity with overseas operations will have to examine everything from its transfer pricing policies, to whether it has appropriately calculated its tax liability in foreign jurisdictions and accurately credited those foreign tax liabilities for U.S. tax purposes. Similarly, a business with a purely domestic focus will have to rethink whether it has sufficient "nexus" to be subject to tax in every state and local jurisdiction in which it has some business contact, as well as whether it has properly allocated income and expense between multiple jurisdictions in the United States. The Tax Practice Group at Womble Carlyle has international tax practitioners, state and local tax experts and a host of other experienced tax attorneys who can assist you in evaluating the merits of a federal or state and local tax position.

The following Womble Carlyle tax attorneys are available to address any questions that you may have regarding FIN 48 in general and the related matters specifically discussed in this Client Alert. Please contact the attorney with whom you usually work or any one of the following attorneys who will be happy to help you solve your FIN 48 compliance issues.

Womble Carlyle Tax Group
Mark Wiley
Neill Edwards
Howard Solodky
Zion Levi
Jeff Lawyer
Lyn Odom