Public Company Experiences with FIN 48 Provide Map for Private Companies

California CPA magazine: December 2007

By Joseph S. DeTrane, CPA

With their public company colleagues having already danced with FIN 48, it’s time for private companies to consider addressing the rules for the first time. Though FASB’s Nov. 7 proposal to defer FIN 48’s application for one year, until period beginning after Dec. 15, 2007, may give private companies more time to comply, it’s still worth looking at experiences public companies had and getting a jump on the process. At press time, FASB was developing a staff position on the delay, which would be subject to a 30-day comment period.

Public companies first addressed the impact of FASB Inter­pretation 48, Accounting for Uncertainty in Income Taxes, in their SEC filings for the quarter ending March 31, 2007. FIN 48 was effective for financial statements issued for fiscal years beginning after Dec. 15, 2006.

Implementing FIN 48 presents private companies with some unique challenges that public companies don’t usually face:
•    Private companies are generally smaller and, consequently, often lack internal tax personnel.
•    They are not subject to the Sarbanes-Oxley Act and may not have developed good internal tax controls.
•    They may have little or no audit history with taxing authorities because of their smaller size.
•    Their shareholders can be more focused on tax savings than public company shareholders and may take more aggressive tax positions.

Still, despite the differences, there are many lessons to be learned from the experience public companies have had with applying the new rules.

Lessons Learned

Start the FIN 48 process soon. Private companies don’t know how long it will take to complete the FIN 48 review until it’s done. Depending on the complexity of the company, it could be a two-to six-month process. Also, it’s important to get it right the first time, as a change could result in a restatement of the financial statements if an error is discovered later.

Develop an inventory of federal, state or international tax positions taken. The positions should include decisions regarding whether to file a tax return in a specific jurisdiction. Positions include those that are the same as financial book treatment, as well as those that are treated differently.

Determine the level of materiality. FIN 48 encompasses a review of tax positions that are material to the financial statements.
Determine the open tax years. Tax years can be open under the statute of limitations for a period longer than the typical three-year federal statute or, in some cases, longer than the four-year statute of some states. For example, the statute for the decision to not file in certain jurisdictions may be open forever. Also, in situations of net operating loss and credit carryovers, the statute is open for the tax years that generated the carryover until the statute closes for the year that the loss or credit was utilized.
Recognize that the “more likely than not standard” under FIN 48 is different than the standard used for tax returns filed in prior years. For tax returns, the standard for avoiding penalties is that the tax position has a reasonable basis for being sustained under audit by the tax authority. On a percentage basis, there is a one-in-three chance of being successful. The more likely than not standard assumes that the taxpayer has a greater than 50 percent chance of being sustained in an audit. Also, recognize that most tax studies, such as research and experimentation and transfer pricing, are prepared on a reasonable basis rather than a more likely than not basis.

Ensure that your tax advisers and independent audit firm are on the same page as to the expectations of the FIN 48 analysis. Specifically, will the focus be on the gross deferred tax assets and liabilities or the net deferred tax assets and liabilities? For example, a company with large net operating losses may have a full valuation allowance and, consequently, zero net deferred tax assets. Does this result in a shortened process? Probably not. As FASB indicated, the analysis should occur before the consideration of valuation allowances. As of now, companies have to evaluate material tax positions and the gross deferred asset or liability even if there is a full evaluation allowance.

Completing the studies. What happens if you have not completed a transfer pricing study; an IRC Sec. 382 study on the availability of a net operating loss or credit carry over; an R&E study; or a reasonable compensation study? How do you determine the likelihood of being successful in an IRS or state tax audit? Initially, the tax authority will likely disallow the tax position in the absence of a study—not that the study is a guarantee of succeeding with the tax authority. The study likely concludes at a reasonable basis level (one-in-three chance of success) and with further insight you could get comfortable at a more likely than not level (greater than 50 percent).

Change your assumptions. Under FIN 48, companies have to work under the assumption that the tax authority will review the tax position, even though it may not.

How do you get to a more likely than not conclusion? This depends on the taxpayer. One consideration is the likelihood of settling the issue. This consideration relies in part on the fortitude of the taxpayer to fight for an issue. If a taxpayer is not willing to fight for tax positions, generally the issue is settled at the agent level and often not in the taxpayer’s favor; whereas, a more favorable result may be reached at appeals.

It’s important to stay current with tax authorities. As the authorities change, a position that was previously considered uncertain under FIN 48 may become more certain, and vice versa.

Compiling an Inventory of Tax Positions

The first step in the process of adopting FIN 48 is to identify uncertain tax positions. Specifically, has the company analyzed the appropriate documents and processes to conclude that it has identified all material uncertain tax positions?
This process includes a review of the following documentation:
•    Cumulative inventory of book/tax differences for all open tax years.
•    On a line-by-line basis, the tax returns in all significant jurisdictions for all open tax years. This should include reviewing each significant income and expense item, as well as all significant book/tax differences, elections, statements and attachments.
•    A detailed trial balance for all significant legal entities for all open tax years.
•    The accounting policies for open tax years.
•    Prior year financial statements for all open tax years.
•    All significant acquisitions and dispositions in open tax years, and the related tax due diligence and purchase accounting workpapers, to determine the tax positions taken by the acquired and disposed businesses.
•    The results of any prior income tax audits.
As these documents are reviewed, each tax position identified should be catalogued and put into one of three categories:
Highly certain tax positions: those with essentially no tax risk and nothing other than a brief description as to why the tax law applies clearly to the particular facts.
Uncertain tax positions: those positions other than highly certain positions that require additional analysis.
Immaterial tax positions: those positions that are not material, but should continue to be monitored in case they become material in the future.

Recognition and Measurement

The two key steps in the FIN 48 analysis of any uncertain tax position are recognition and measurement.

In the recognition step, each tax position is evaluated to determine whether it will meet the more likely than not standard. A key requirement of FIN 48 is that a company must assume it will be audited, and that the taxing authority will evaluate the technical merits of each tax position. Thus, even if a private company has never undergone a tax audit, it must analyze its tax positions as if it will.

As a practical matter, most of the effort in a FIN 48 analysis is focused on those positions that are close to the more likely than not threshold (e.g., positions in the range of a 40 percent to 70 percent chance of success).

If a position has only a 25 percent to 40 percent chance of success, regardless of where the position ends up in that range, it will be below the more likely than not threshold and thus 100 percent of the position’s tax benefit will be unrecognized for financial statement purposes.

On the other end of the spectrum, positions with a certainty of more than 70 percent may require less documentation, as those positions will clearly meet the more likely than not threshold.

In evaluating whether or not a position meets the more likely than not threshold, care must be taken when relying on previous tax opinion letters or other work performed by an external consultant.

Firstly, the advice must be rendered at the appropriate unit of account level—a new concept under FIN 48. Next, a tax opinion letter may need to be updated to reflect recent technical developments. And finally, the opinion letter must be reviewed to determine that appropriate reliance on facts or assumptions, such as valuation appraisals, has been considered.

Certain tax projects performed by outside consultants may not include a tax opinion at the more likely than not level. If a company hired a consultant to perform a transfer pricing study, for example, the study will rarely provide a more likely than not conclusion. Thus, a company will likely need to prepare further technical analysis to determine if it meets the more likely than not criteria.

Once it is determined that an uncertain position meets the recognition criteria, it must be further evaluated to discern the measurement of the amount of the benefit that can be recorded. This is a very subjective aspect of FIN 48.

Some positions will be all or nothing, which means if the position meets the more likely than not threshold, then 100 percent of the benefit from the position will be realized. Examples include whether an item is taxable, whether an item is capital or ordinary, whether a reorganization is tax-free, whether nexus has been established in a state or whether a permanent establishment is created in a foreign jurisdiction.

A greater majority of tax positions that meet the more likely than not standard will require measurement of the certainty to determine the benefit to be recognized. The quality of the documentation supporting a tax position can have a significant impact on its outcome and thus must be considered in the measurement process.

Ongoing Monitoring of Tax Positions

Amounts reserved under FIN 48 for unrecognized tax benefits should not be changed unless new information comes to light in a subsequent reporting period. A change in the interpretation of the tax law, for example, is considered new information and thus will have to be monitored to determine its impact on the amount of any unrecognized tax benefits.

This requirement to monitor changes in tax law and their impact on existing (and new) tax positions will be especially challenging for private companies, as they tend to have fewer qualified in-house tax personnel. These companies may need to rely more heavily on outside tax consultants to monitor technical developments.

Disclosures

Various disclosures in financial statement footnotes are required in connection with the adoption and ongoing FIN 48 compliance. The two disclosures most likely to be troublesome to private companies are the “tabular reconciliation” and the “12-month” disclosures.

The tabular reconciliation is an annual reconciliation of all activity in unrecognized tax benefits by category. The categories include reserves added in the current year, prior year reserves adjusted, payments to taxing authorities and reserves reversed due to lapsing of the underlying statute of limitations.

For larger companies, the disclosure of amounts by category will not be problematic, as they will likely have a large number of unrecognized tax benefits in each category and are generally subject to many taxing jurisdictions. For private companies, which do not have as many unrecognized tax benefits and may be subject to only a few taxing jurisdictions, the required disclosures could reveal more information to the tax authority than they would like.

The “12-month” disclosure is required when a significant adjustment to the unrecognized tax benefit is expected within 12 months of the report date (year end).

For example, if 50 percent of a company’s unrecognized tax benefit relates to a federal position in its 2004 calendar return, that position will expire upon the lapsing of the statute of limitations for the 2004 tax year (generally, Sept. 15, 2008, assuming the return was extended).

That means that a disclosure would likely be required in the 2007 annual report indicating that 50 percent of the company’s unrecognized tax benefit is likely to change within 12 months due to the lapsing of the underlying statute of limitations along with a description of the nature of the underlying issue. These disclosures will no doubt be of interest to the taxing authorities.

The Music Has Started

The adoption of FIN 48 by a private company will require companies to learn a few more moves and take a fresh look at its tax positions. Documenting and monitoring these positions and identifying new positions in the future will take effort, but the process will prepare the company for any potential tax audit and can enlighten management as to the importance of managing tax risk. 

Joseph S. DeTrane, CPA is a partner in Grant Thornton’s Greater Bay Area tax practice. You can reach him at Joe.DeTrane@gt.com.