Corporate Tax - USA

Background

In June 2006 the Financial Accounting Standards Board (FASB) issued FASB Interpretation No 48 (FIN 48) revising the rules on how companies account for uncertain tax positions.(1) This changed the fundamental accounting rules for tax positions by imposing a ‘more-likely-than-not’ recognition standard on uncertain tax positions. The tax community responded negatively and the Tax Executives Institute urged FASB to delay implementation - to no avail.(2) Many practitioners and academics predicted that FIN 48 would have a significant impact on different aspects of the tax system.(3) In relation to companies it was expected to:

• influence financial statements;
• expand tax disclosures; and
• affect dealings with the Internal Revenue Service (IRS).

FIN 48 took effect on January 1 2007 for calendar-year companies and the practical effects are beginning to be seen. Some of the early predictions have turned out to be correct, although many questions remain unanswered. Overall, the feeling is that FIN 48 is not making the significant impact that some predicted. This is mainly because:

the financial statement adjustments from FIN 48 have been relatively small;

the IRS has maintained its ‘policy of restraint’ - at least so far; and

the public disclosures have been less than revealing. 

As a result, the biggest impact might be felt in the international arena. Foreign jurisdictions do not generally have a policy of restraint and can ask for tax accrual paperwork. If foreign jurisdictions become aware of this potential resource and begin requesting FIN 48 paperwork, companies may provide the blueprint to other countries rather than the IRS.

Overview

FIN 48 addresses how companies must recognize, measure and disclose the uncertain tax positions taken on past tax returns or they expect to take on future returns. A company’s financials should reflect the expected future tax consequences of its tax positions, assuming full knowledge of the position and related facts by the IRS and other tax authorities. FIN 48 further requires companies to increase disclosure of their tax positions on financial statements - including a tabular roll-forward of all unrecognized tax benefits.

FIN 48 applies only to income taxes (not all taxes) that are accounted for under FASB Statement 109. It therefore amends FASB Statement 5 ("Accounting for Contingencies") so that it no longer applies to income taxes. Statement 5 still applies to other taxes, such as sales and use taxes, as well as most other contingent liabilities.

Under Statement 5, companies would recognize their claimed tax benefits and then create a reserve for contingent tax positions based on how likely it was (‘probable’, ‘reasonably possible’ or ‘remote’) that the position would cause a liability. FIN 48 reverses this framework and imposes an income-recognition model which states that each tax position must have a more-likely-than-not chance of being sustained on its merits before the tax benefits are recognized. Once a position passes this threshold, companies must measure the expected tax benefits using a complicated cumulative-probability approach. Additionally, companies must book any interest and penalties associated with uncertain tax positions.

FIN 48 has a broad scope also. It covers, for instance:

• decisions to exclude income and transactions from the return;
• decisions not to file returns in a specific tax jurisdiction (eg, other countries); and
• situations requiring the filing of amended returns or refund claims.

FIN 48 is effective for fiscal years beginning after December 15 2006. As a result, calendar-year companies are required to reflect any adjustments in their January 1 2007 retained earnings. Finally, FIN 48 needs to be implemented for quarterly reporting, thus most calendar-year companies implemented it in their Form 10-Q for the first quarter of 2007.

Initial Answers to Six FIN 48 Questions

Has FIN 48 had a significant impact on companies’ financial statements?

FIN 48 has not had an impact on companies’ financial statements as much as some - including tax executives themselves - predicted. A few companies did make major adjustments to their retained earnings and unrecognized tax benefits, but they were the exception and the adjustments did not all go in the same direction - there were almost as many positive retained earnings adjustments as negative adjustments.

Three James Madison University accounting professors published a study recently on the early indications of FIN 48’s impact on financial statements.(4) They reviewed the first quarter Form 10-Qs for the Fortune 200 companies. Due to some adjustments their ultimate sample size was reduced to 130 companies. They reported the impact of FIN 48 on each company’s:

• retained earnings;
• unrecognized tax benefits; and
• recognized interest and penalties.

The results were surprising. The study showed that implementing FIN 48 had an immaterial or negligible effect on most companies’ retained earnings. One aspect of implementing FIN 48 was for companies to go through and re-test all tax contingencies under the FIN 48 model. This means that all less-than-50% issues should be 100% reserved and all other issues should be measured using FIN 48’s cumulative-probability measurement system. Any change in reserve from this exercise should have been made as a retained earnings adjustment on January 1 2007. Many predicted that the retained earnings' impact from these changes would be significant,  but it was relatively minor. A few companies had major reductions to retained earnings. Ford Motor Company, for instance, increased its retained earnings by $1.3 billion. Conversely, Wyeth and Dow Chemical each reduced its retained earnings by roughly $300 million. Most companies, however, made little or no adjustments. Eighty eight percent of companies made retained earnings adjustments that equalled less than 1% of equity and only three companies (out of 130) reported adjustments that exceeded 3% of equity. Almost all companies therefore had an immaterial adjustment to retained earnings.

This trend continues with unrecognized tax benefits. Some predicted that companies would have to report large unrecognized tax benefits. Prior to 2007, FIN 48 companies did not need to report their unrecognized tax benefits, so change figures are unavailable. The nominal unrecognized benefit numbers are not shockingly high. Almost all companies (125 out of 130) reported some unrecognized tax benefits. But most (92 out of 130) reported less than $1 billion in unrecognized benefits. Only eight companies reported more than $3 billion in unrecognized tax benefits. These reported figures show significantly smaller unrecognized benefits than a group of tax executives predicted in November 2006.(5)

Finally, the companies also reported few penalties and interest charges. While some firms reported large future interest and penalties (Merck reported $2.4 billion), most companies reported no penalties or interest, or only small amounts. Eighty one of the 130 companies surveyed reported less than $100 million in future penalties and interest.

Why were these initial impact numbers so underwhelming? There are two main answers, and in likelihood the truth is a combination. First, practitioners and other commentators (and the tax executives themselves) probably overreacted. When new rules are put in place there is a tendency to overstate the impact. Second, the auditors might have been wary to impose FIN 48 too strictly on companies for the first application. FIN 48 is new and difficult for auditors also, and auditors probably do not have systems and techniques in place to ensure full compliance at this early stage. It often takes time for auditors to strike a balance when enforcing new pronouncements. More will be learnt about FIN 48’s true impact in time. In a few years there will be a better understanding of how much FIN 48 changed the tax-reporting landscape.

Do the revised tax footnotes create a ‘roadmap’ for the IRS?

It is difficult to answer this question looking at a small sample of Form 10-Qs. However, the general notion is that the post-FIN 48 tax footnotes will not provide substantial assistance to IRS examiners. It was first thought that public FIN 48 disclosures would reveal more detailed information about a company’s tax positions and that the IRS could use this information to spot new audit issues. Practitioners also worried that the IRS would know how strongly the company believed in each issue because the IRS would see the change in unrecognized tax benefits on an issue-by-issue basis. These concerns do not appear to be materializing. Rumours of the death of vague tax footnotes have been greatly exaggerated.

The reason these worries are not materializing is that companies (and their auditors) are still grouping all of their issues together:

• There has not been issue‑by‑issue reporting;
• ompanies are just giving total numbers; and
• these total figures do not help the IRS spot issues. 

For instance, the IRS may find it interesting that a company’s unrecognized tax benefits have doubled in the past year - and that may give the IRS a signal in the unusual case. However, in the usual case, revealing the change in the total unrecognized tax benefit is unlikely to help the IRS.

Wal-Mart’s tax footnote from its most recent Form 10-Q illustrates how the revised tax footnotes will not be a road map for the IRS. Wal-Mart’s June 1 2007 Form 10‑Q for the quarter ending April 30 2007 is below. It reveals that implementing FIN 48 made Wal-Mart increase its unrecognized tax benefits by $236 million and reduce its opening retained earnings by $160 million. The footnote reads as follows:

Wal-Mart’s disclosure is a good example of how a footnote can provide the requisite high-level information without giving the IRS a roadmap. It is difficult to see the IRS gaining any advantage in its audit by reading the footnote. The better analogy used by some is that the revised public disclosures provide the IRS with a ‘compass’ rather than a roadmap - but even that may be going too far.

Will the FIN 48 work papers be considered tax accrual work papers?

In auditing a company’s tax provision the auditors receive several internal documents describing the company’s tax issues. These documents - called tax accrual paperwork - can show the underbelly of a company’s tax position. The company would naturally prefer not to turn over the paperwork to the IRS. Moreover, the paperwork is often not privileged because giving it to a third party (the auditor) generally waives the privilege. Companies can argue that some of the documents are protected by the work product doctrine - and probably will assert it more in light of Textron. Nevertheless, the IRS generally has the right to ask for a company’s tax accrual paperwork.

However, the IRS has a policy of restraint in the Internal Revenue Manual whereby it promises to ask for tax accrual paperwork in extraordinary circumstances only or when a company does not disclose participation in listed transactions.(6) Thus it is important for documents to be classified as part of the tax accrual paperwork so that the documents fall under the IRS’s policy.

Initially, there was concern that the FIN 48 paperwork (eg, the cumulative-probability analyses) would not be classified as tax accrual paperwork. (7) This would expose the documents to routine requests by the IRS for “all materials related to 'X' transaction”. The IRS recently decided, however, that FIN 48 paperwork constitutes tax accrual paperwork. This designation helps companies in that they do not have to draw lines around what is FIN 48 paperwork and what is tax accrual paperwork.

Will the IRS change its policy of restraint on tax accrual work papers because of FIN 48?

The IRS has the right generally to request tax accrual paperwork. In the 1980s, a taxpayer challenged this right and the IRS prevailed in the Arthur Young(8) Supreme Court case. Taxpayers can withhold documents in the tax accrual paperwork that are either privileged or work product, but not on other grounds. However, the IRS does not routinely ask for companies’ tax accrual paperwork, partly because it would hamper the companies’ ability to communicate honestly with their auditors. The IRS formalized this policy of restraint in the Internal Revenue Manual, but the policy is not absolute. The IRS has always had an exception for ‘extraordinary circumstances’ and in 2002 the IRS amended the policy to say that it would ask for limited tax accrual paperwork if a company did not disclose one listed transaction and all tax accrual paperwork if the company did not disclose multiple listed transactions.(9)

The IRS has been thinking about changing its policy of restraint over the previous year. It realized that FIN 48 would cause companies’ tax accrual paperwork to include more useful information (eg, cumulative probability analyses, issue-by-issue penalty assessments) and has decided to revisit the policy. This is also part of the IRS’s recent focus on enforcement issues, led by former Commissioner Mark Everson.

While the IRS has not changed the policy yet, several senior Large and Mid-size Business (LMSB) Division officials have indicated that the policy is under review. LMSB Commissioner Debbie Nolan has publicly said that the service is reviewing the policy and LMSB senior adviser Bob Adams said in July that the IRS is still considering changes to the policy.(10) Other IRS officials - most notably Chief Counsel Don Korb - have downplayed the possibility in public comments. The IRS will probably retain its current policy of restraint in the short-term. The recent departure of Everson and the retirement of Nolan will probably cause the IRS to delay making such a major change. If a change is made, it would probably be made after a new administration is in place and a new IRS commissioner is confirmed.

Can companies use attorney-client privilege or work product to protect their outside advice on transactions?

Companies can protect some documents in their tax accrual paperwork using attorney‑client privilege or work product, but it is difficult. The attorney-client privilege (and the corresponding tax-practitioner privilege in Section 7525) protects legal and tax advice given to clients. Many documents in the tax accrual paperwork can fit under the privilege, although sometimes it is difficult to distinguish ‘legal advice’ from ‘tax return preparation’.

The problem with companies trying to invoke the attorney-client privilege is usually one of waiver. When a client discloses privileged communications to third parties the disclosure waives the privilege with respect to that document and can waive the privilege over the entire subject matter. This happens often with tax accrual paperwork because the auditor will ask to see the opinions or other privileged documents on certain issues, and when the company gives the documents to the auditor it waives the privilege because the auditor is a third party. Sometimes taxpayers try to argue that there is no waiver because the auditor is part of the team and the auditor’s review is actually tax advice covered by Section 7525, but this argument has never succeeded in court.

The better alternative for protecting documents in the tax accrual paperwork is the work product doctrine, which protects materials prepared or gathered by an attorney in anticipation of litigation. The idea behind this privilege is that lawyers need to be able to write down their litigation ideas and strategies privately, without having to turn over their ideas to adversaries.(11) Unlike the attorney-client privilege, the work product privilege is a qualified privilege, meaning that it may be overcome by a showing of ‘substantial need’. The recent Textron(12) decision is an advantage for taxpayers on this issue. Textron was able to protect a spreadsheet in its tax accrual paperwork that included counsel’s judgments, in percentage terms, about all of Textron’s sensitive tax positions and the monetary amounts reserved for each position. Textron also protected earlier drafts of the spreadsheet and a memo written by its in-house attorneys reflecting their opinions on each issue. The district court held that these documents were prepared in anticipation of litigation and let Textron protect the documents under the work product doctrine. The IRS chief counsel, Don Korb, indicated that the IRS does not agree with the court’s holding and will probably appeal.(13)

Will foreign countries start asking for tax accrual paperwork?

The IRS is not the only relevant taxing authority for multinationals. Most large companies must interface with foreign tax authorities also. Some commentators have noted that FIN 48 might pique other countries’ interest in obtaining tax accrual paperwork because it requires companies to have more substantive materials (eg, memos, predictions) in the paperwork. One particularly sensitive area could be the existence of a permanent establishment in a foreign country. A company might have operations in another country but take the position that it has no permanent establishment and pay no taxes there. If the company believes there is a risk that it would lose a permanent establishment challenge, this would be an uncertain tax position covered by FIN 48. If the company thinks that it is more likely that it would lose a permanent establishment challenge it must fully reserve on this issue. Other countries may wish to see the FIN 48 paperwork to investigate how the company views its chances on the permanent establishment issue.

Transfer pricing is another area where FIN 48 could cause problems for companies audited in another jurisdiction. Companies often set up reserves to cover their potential transfer-pricing adjustments. Prior to FIN 48 there was probably little documentation of the reserve calculations in a company’s tax accrual paperwork. With FIN 48, the tax accrual paperwork involving transfer pricing will be more revealing for two reasons. First, companies that do not want to reserve for transfer-pricing issues will have to convince their auditor that it is more likely that there will be no adjustment. To do this, companies must obtain opinions or take other actions that they would not have taken under Statement 5. FIN 48 also prohibits companies from factoring detection risk into the analysis. It does not matter if the foreign jurisdiction has insufficient resources and is unlikely to audit a company’s transfer pricing. FIN 48 requires that all tax positions must have a more-than-50% chance of winning on its merits. Second, FIN 48’s cumulative-probability analysis will probably make the paperwork relating to transfer-pricing adjustments more detailed. Companies are supposed to schedule the likelihood of each audit outcome as part of this exercise. Other countries would be interested in seeing this information in their transfer-pricing examinations.

Additionally, most countries presumably do not have a policy of restraint similar to the IRS’s policy. This means that foreign jurisdictions could request tax-accrual paperwork from multinationals. Many countries’ revenue authorities are probably unfamiliar with generally accepted accounting principles tax reporting in general, and FIN 48 in particular. Most non-US auditors probably do not know that these companies are required to create tax-accrual paperwork that has this level of detailed analysis and predictions. When foreign jurisdictions learn about these developments in tax reporting for US companies they might decide to request these records. If so, it could make a significant impact on foreign examinations. Companies should be aware of this possibility and be careful about what documents become part of the tax accrual paperwork. Even if the IRS does not ask for the paperwork, other countries might request it.

These overseas tax jurisdictions could theoretically share the paperwork with the IRS under information-sharing treaties. While this is a possibility, LMSB Senior Adviser Bob Adams said in July that he is unaware of any such requests involving tax-accrual paperwork.

Comment

FIN 48 has in some ways entered with a whimper. It has changed the rules on how to report tax contingencies and it has created much more documentation for companies and auditors to review in evaluating a company’s tax contingencies. However, it has not made a significant impact on most companies’ financial statements or retained earnings. Moreover, the revised disclosures have not created the road map for the IRS as many had feared. It is still early in the implementation process and it is still to be seen where the balance ultimately falls, but the initial look at FIN 48’s impact shows that it has not changed the tax-reporting landscape as much as some thought that it might. The real impact could be in the international area if other countries begin to request tax accrual paperwork.

Endnotes

(1) FIN 48 was issued in draft form on July 14 2005.

(2) Boyle, “TEI Urges FASB to Withdraw Exposure Draft”, 109 Tax Notes 125 (October 3 2005).

(3) See, for example, Kimmelfield, Horowitz and Davis, “Accounting for Uncertainty in Income Taxes - The Effect of FASB FIN 48”, The Tax Executive (July-August 2006).

(4) Nichols, Briggs, and Baril, “And the Impact Is . . . First-Quarter Results From Adopting FIN 48” 116 Tax Notes 377 (July 30 2007).

(5) Shaw, “Uncertainty Reigns Over Taxes: Controllers Are Wary About Accounting Guidance For Uncertain Tax Positions that was Supposed to Lessen Confusion and Varied Practices”, www.CFO.com, November 7 2006.

(6) IRM Section 4.10.20.3. The IRS’s prior position on tax accrual paperwork is at Announcement 84-46, 1984-1 IRB. 18.

(7) LMSB-04-0507-044, Doc 2007-15353 (May 10 2007)

(8) 465 US 805 (1984).

(9) Announcement 2002-63, 2002-2 CB 72.

(10) Jaworski, “Panel Debates Effect of FIN 48 on Transparency, Compliance”, 116 Tax Notes 237 (July 23 2007).

(11) United States v Adlman, 134 F3d 1194, 1196 (2d circa 1988).

(12) 100 AFTR 2d 2007-XXXX, August 28 2007.

International Law Office