First FIN 48 Disclosures Show Tax Struggles

Holding their collective breaths as they prepare to file their first-quarter financial reports, companies are anxious to see how investors and tax authorities will react to their heightened level of disclosure about uncertain tax issues.

The market’s largest public companies are fast approaching the filing deadline for the first quarterly period in which they must comply with Financial Interpretation No. 48, Uncertain Tax Positions. The regulation forces companies to analyze outstanding tax issues and confess where they may have doubts about whether tax authorities will agree with tax breaks the companies are claiming.

Tax experts familiar with the process say corporate tax departments have been bustling with activity to comply with the new interpretation—not to mention a good bit of doubt about exactly how to do so.

Companies deluged the Financial Accounting Standards Board in late 2006 and early 2007 with requests to delay FIN 48, saying they weren’t adequately prepared and had questions about what the interpretation meant. Unsympathetic, FASB kept to its original timeline but promised some still-in-development guidance about a narrow question regarding when a tax issue can be seen as fully resolved.

John Feeney, a tax partner with accounting firm Grant Thornton, says companies got off to a late start, waiting to see if FIN 48 would be delayed. “Everyone was hoping this thing would get pushed back,” he says. “People are pretty stretched as it is, but relief did not come.”

Neuenhaus

Even as companies file their first reports, they will do so with some trepidation, experts say. “Companies are still trying to figure out how this will play out,” says David Neuenhaus, partner with tax law firm Neuenhaus Helverson. “The whole industry is just getting their legs under themselves and figuring out how this is going to be coordinated.”

The looming fear is how the Internal Revenue Service will react, says Terry Haines, a partner with the law firm of Buchanan Ingersoll & Rooney. The market worries that the IRS will use FIN 48 disclosures as a roadmap to audit companies more carefully, a scenario that even some FASB members continue to debate as the Board develops its settlement guidance.

“One of the things companies have to figure out is how the revenue authority, sometimes in an adversarial position, is going to deal with it,” Haines says. “It adds an element of subjectivity. There’s no way to know for sure what the IRS might want.”

One issue FASB tried to settle as FIN 48 took effect was a lingering question about how much documentation companies need to provide for highly certain tax positions. FASB and the Securities and Exchange Commission both assured Corporate America that they did not expect companies to throw the book at every last tax position they claim, but would focus documentation interests on the uncertain positions.

Gaps In Trust, And In Tax

Still, companies have continued to worry about how much of that documentation about uncertain positions will ultimately end up in the hands of the IRS. It’s been an intense tango between legal counsel and auditors, experts say, because anything a company provides to the auditor to substantiate a tax position for reporting purposes becomes part of the auditor’s work papers. That means it loses the protection of attorney-client privilege and becomes fair game for a tax auditor down the line, says Adam Gropper, a tax partner with the law firm of Baker Hostetler.

“A tax attorney provides advice to the company; then the accountant says, ‘Tell me about the advice your attorney provided to you,’” Gropper explains. “To the extent you share that with the accountant, the privilege is lost.”

In the past, such worries were rare because tax lawyers weren’t often involved in the process, Gropper says. “Now to the extent the tax lawyer is involved and writes those judgments down, and then that’s communicated from the company to the accountants—that information is where you have a privilege problem.”

RULE EXCERPT

Below is the proposed FASB Staff Position to clarify when a tax position is considered settled.

FASB Staff Position

4. For purposes of applying paragraph 10(b) of Interpretation 48, settlement has effectively occurred if the taxing authority has completed all of its required or expected examination procedures, the enterprise does not intend to appeal or litigate any aspect of the tax position, and it is considered highly unlikely that the taxing authority would reexamine the tax position.

5. When all of the following conditions have been satisfied, a tax position shall be considered effectively settled through examination:

The taxing authority has completed its examination procedures including all appeals and administrative reviews that the taxing authority is required or expected to perform for the tax position.

The enterprise does not intend to appeal or litigate any aspect of the tax position for the completed examination.

Based on the taxing authority’s widely understood policy, the enterprise considers it highly unlikely that the taxing authority would subsequently examine or reexamine any aspect of the tax position included in the completed examination, presuming the taxing authority has full knowledge of all relevant information.

In the tax years under examination, a tax position does not need to be specifically reviewed or examined by the taxing authority to be considered effectively settled through examination. If the taxing authority has specifically examined a tax position during the examination process, an enterprise shall consider this information in assessing the likelihood that the taxing authority subsequently would reexamine that tax position for

the completed examination.

6. If an enterprise that had previously considered a tax position effectively settled becomes aware that the taxing authority may examine or reexamine the tax position, the tax position is no longer considered effectively settled and the enterprise shall reevaluate the tax position in accordance with Interpretation 48.

7. An enterprise may obtain information during the examination process that enables that enterprise to change its assessment of the technical merits of a tax position for similar tax positions taken in other periods. However, the effectively settled conditions in paragraph 5 of this FSP may not be the sole basis for the enterprise to change its assessment of the technical merits of any tax position in other periods...

Source

Proposed FASB Staff Position No. FIN 48-a, "Definition of Settlement in FASB Interpretation No. 48" (March 2007)

Roger Pies, also a tax partner with Baker Hostetler, says the IRS has typically acted under a policy of restraint when it comes to a company’s financial statement audit work papers, but he wonders whether the policy may change as the IRS faces increasing pressure to collect more of the tax via the tax audit process. Some estimates peg uncollected taxes at more than $300 billion every year.

“People talk about the tax gap. Rather than raise taxes, why not collect the ones currently owed?” Pies asks. “If they’re under pressure to perform, then they may reconsider whether to continue a policy of restraint. The policy matter is an ongoing issue and it’s not 100 percent certain where it will come out.”

Dicker

Eli Dicker, chief tax counsel for the Tax Executives Institute, said there’s a stigma on assertions of attorney-client privilege over tax documents. “There’s a certain sense in the tax community in the compliance environment that privilege is bad,” he says. “If you are cloaking behaviors in privilege that means you have something to hide and that runs afoul of greater transparency.”

Companies are navigating that tension cautiously, Dicker says. “They have engaged in dialogue and discussion with their legal advisers to provide them with information that can satisfy the auditor but perhaps remains within a zone of privacy,” he says. “That’s squishy. It’s a very, very soft area right now.”

Traci Hollingsworth, vice president of finance for Manufacturers Alliance/MAPI, says many companies still have lingering questions as well about tax nexuses—that is, whether they even owe taxes in particular jurisdictions where they may have had only minimal or passing business activity. Typically, companies simply don’t file returns in jurisdictions where they see a low risk of tax compliance problems, but some companies are rethinking that strategy in light of FIN 48, she says.

“Not filing is important because you don’t trigger a statute of limitations,” she says. “If you file in the U.S., after three years the statute of limitations expires and you’re not audited. But if you never file, you never do the first thing that closes the statute of limitations.” The statute of limitations is important because it’s one of the key litmus tests for when a tax issue is considered “settled” and therefore certain—and exempt from disclosure—for FIN 48 purposes.

Feeney

Feeney says he expects to see widely varying impacts of FIN 48 disclosures on companies’ financial statements. Year-end 2006 annual reports carried broad early disclosures about the expected effects of FIN 48, and they suggested that some companies believe they reserved too much for tax liabilities rather than too little.

“Some companies will be taking charges to retained earnings,” he says. “A lot of companies will be taking back a substantial amount, taking down their tax reserves and recording benefits to retained earnings. There is such a level of subjectivity in income taxes, but with FIN 48, there’s a more narrow range of subjectivity toward estimates. We really have companies all over the map as to their facts and circumstances.”