Understanding FIN 48, Accounting For Uncertainty In Income Taxes,

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					         Understanding FIN 48, Accounting For
         Uncertainty In Income Taxes, And Resulting
         Implications Under Sarbanes-Oxley

                                                    Jerald David August and Jordan David August

                                                    This is another in a continuing series of articles
                                                    written by members of the ABA Tax Section in
                                                    which a senior member of the Section teams up
                                                    with a member selected from the Section’s Young
                                                    Lawyers Forum.

Jerald David August                                 Corporate taxpayers, as with many
is Co-Chair of the Tax and Estates Department       types of taxpayers, frequently consider tax
of Fox Rothschild LLP. A frequent lecturer          minimization or avoidance strategies. Invariably, this
throughout the United States on federal tax         evaluation concludes with whether a taxpayer should go
matters, he is past Vice-Chair (Publications) of    forward with a particular planning strategy or possibly
the ABA Section of Taxation and a member of         weigh competing strategies. In many cases a principal
the Editorial Board of The Practical Tax Lawyer.    goal of the selected strategy is to reduce or defer current
Mr. August is a longstanding member of the          period Federal (and/or state) income tax liabilities. (When
Advisory Board of the New York University           a tax opinion is rendered, certain compliance and ethical
Institute on Federal Taxation and has served as     issues are implicated. §§6694, 6664(c). See Circular 230,
Chair of the Institute on Federal Wealth Taxation   31 C.F.R. §10.35(c) (covered written opinion rules; “prin-
(2006-2008).                                        cipal purpose,” “significant purpose”). For reporting rules
                                                    and list maintenance requirements for certain “report-
Jordan David August                                 able transactions” see Treas. Reg. §1.6011-4.) The objec-
is a Second Year Law Student at the University      tive of reporting a reduced tax liability as a consequence
of Florida, Levin College of Law, Gainesville,      of entering into one or more tax-efficient transactions is
Florida. He received his B.S. in Accounting         to facilitate a corresponding reduction in the taxpayer-
from the Fisher School also at the University       company’s current or projected cash outflows, including
of Florida. He is a Law Student Member of           estimated tax and tax reserves. Where projected tax sav-
the ABA Tax Section. He is presently working        ings are currently viewed by management as ultimately
as a Fellowship Law Student with the Senate         being realized, the projected amount of the benefit is fur-
Finance Committee in Washington, D.C.               ther reflected on the balance sheet of the taxpayer as an
                                                                                    The Practical Tax Lawyer | 19
20 | The Practical Tax Lawyer                                                                      Summer 2008

indirect increase to retained earnings, i.e., by not      the possible payment of taxes upon audit may have
being included as a contingent liability in the re-       been completely left off the taxpayer’s tax reserve.
serve for taxes.                                              This liberal yet amorphous standard yielded
     Not all of a reporting enterprise’s planned po-      diverse approaches for booking reserves for taxes.
sitions taken on a tax return, however, will be sus-      More particularly, when the likelihood that a par-
tained in the event of an audit. If a particular re-      ticular reported tax position would ultimately be
porting position is successfully challenged in court      sustained was uncertain, FAS 109 had no specific
by the IRS, settled by agreement, or conceded by          guidance on how and whether the position should
the taxpayer in whole or in part, the taxpayer will       be booked to a reserve for tax liabilities, and the
incur an interest cost which accrues from the due         amount of the charge if booked. As a result, di-
date of the return, i.e., the required date of pay-       verse accounting practices developed to reflect tax
ment, as well as a possible penalty (and deficiency       reserves. This inconsistency in recognizing, derec-
interest on such penalty) until the date of payment       ognizing, and measuring benefits and liabilities as-
(or if earlier, when a deposit in the nature of a cash    sociated with income taxes made it difficult for in-
bond is made). §§6601, 6603, 6621(a)(2). Although         vestors to properly analyze and compare financial
                                                          statements of different enterprises.
tax returns that initially report a favorable outcome
or result on one or more issues reflect the benefit of
                                                          fin 48 • In light of other relatively recent financial
a reduced current tax liability owed by a corporate
                                                          reporting issues and business scandals, the Securi-
taxpayer (or increase in a reportable net operating
                                                          ties and Exchange Commission, particularly after
loss or increase to a claim of refund), the claimed
                                                          the enactment of the Sarbanes-Oxley Act, H.R.
tax benefits still have to be analyzed for financial
                                                          3763, 107th Cong. (2002) (“SOX”), was critical
reporting purposes to avoid being shown as con-
                                                          of the lack of consistency and transparency in ac-
tingent tax liabilities includible in a properly estab-
                                                          counting for uncertainty in income taxes. This crit-
lished reserve.
                                                          icism led to the adoption of FIN 48. FASB Inter-
                                                          pretation No. 48, “Accounting for Uncertainty in
fasB 109 • Before the adoption of FAS Interpre-
                                                          Income Taxes—an interpretation of FASB State-
tation No. 48 (“FIN 48”), Financial Accounting            ment No. 109,” Financial Accounting Series (June
Standards Board (“FASB”) Statement 109 (adopted           2006).
in 1992) did not set out specific guidance concern-
ing the proper method for reporting uncertainty in        scope of fin 48
income tax liabilities for financial accounting pur-          FIN 48 clarifies the guidelines for accounting for
poses. The approach used before the promulgation          uncertainty in income taxes on financial statements
of FIN 48 was for the reporting entity to increase        of enterprises per FASB Statement No. 109, Ac-
its reserve for taxes based on whether and to what        counting for Income Taxes, and removes uncertain
extent management believed it was likely that the         income tax positions from the guidance provided
positions taken by the taxpayer on returns would          under FAS 5, Accounting for Contingencies. It also
ultimately give rise to an actual liability, including    applies to purchase accounting in connection with
additions to tax. This process involved examining         a business combination. Use of a valuation allow-
whether the outcome with respect to the particular        ance described in FASB Statement 109, therefore,
item or items was probable, reasonably possible, or       is not an appropriate substitute for the derecogni-
improbable. In such latter instances, a charge for        tion of a tax position. The requirement to assess a
                                                                                             Fin 48 And Sox | 21

valuation allowance for deferred tax assets based         expired for the year in which the position(s) were
on the sufficiency of future taxable income is left       taken and the position(s) has not been challenged
unchanged by FIN 48. This situation would arise,          by the taxing authority. Conversely, previously
for example, when a company with a large net op-          recognized tax positions that subsequently fail the
erating loss carryforward is not likely to produce a      “more likely than not” recognition standard due
sufficient level of future taxable income to fully use    to an intervening change in the law are required
the NOL within the applicable carryover period.           to be derecognized and charged to liabilities in the
     When a position is taken on a tax return that        first subsequent financial reporting period in which
reduces the amount of income taxes payable even           such determination is made.
though another interpretation of current law can               When the “more likely than not” standard is
be made that would not reduce those taxes, the en-        not satisfied, as is discussed below, no economic
terprise realizes an immediate economic benefit.          benefit may be claimed and recognized for finan-
Under FIN 48, this benefit of a favorable tax posi-       cial accounting purposes, i.e., a liability is booked
tion can be recognized in the current period when         or reflected on the financial balance sheet for the
the position has a “more likely than not” chance          total amount of tax due, plus associated interest
of being upheld through court review despite the          and penalties.
presence of contrary interpretations, and such
benefit to ultimately be realized can be measured         impaCt of fin 48 on reporting Com-
in accordance with applicable rules. Only the dif-        panies and privately held Com-
ference between the measured benefit and the re-          panies preparing finanCial state-
ported benefit on the tax return is required to be        ments Under gaap • In June 2006, FASB
added to the tax reserve. On the other hand, if the       approved the final version of FIN 48 for generally
position on a particular item, i.e., a so called unit     accepted accounting principles (GAAP) reporting
of account, is determined to be “less likely than         with respect to uncertain tax positions. FIN 48 is
not correct,” the full amount of the tax liability, as    effective for fiscal years beginning after December
well as projected interest and possible penalty, must     15, 2006, for public companies, and, for fiscal years
be included in the reserve as a current liability (or     beginning on January 1, 2007, for non-publicly
reduction in the net operating loss carryforward          traded or privately held calendar-year companies.
or claimed tax refund) when the company antici-           Originally, the same 2006 effective date was to ap-
pates making payment within one year or within            ply to all entities using GAAP for financial account-
the company’s next operating business cycle. Non-         ing purposes. However, based on a November 2007
current liabilities for fully or partially unrecognized   recommendation of the Private Company Finan-
tax positions are treated as a deferred tax liability     cial Reporting Committee, FASB agreed to delay
to the extent unrecognized. Such book-tax adjust-         the effective date until taxable years beginning on
ments will, in certain instances, affect the tax basis    January 1, 2008, for private companies to comply
of one or more assets, thereby differentiating book       with FIN 48. See also FASB Staff Position FIN
from tax depreciation—during the applicable re-           48-2 (2/01/08), (effective date of the FASB Inter-
covery periods.                                           pretation No. 48 for certain nonpublic enterprises,
     In many instances partial or totally unrecog-        including nonpublic non-for-profit organizations,
nized tax positions may not later be derecognized,        to the annual financial statements for fiscal years
i.e., reduce the amount of the reserve or liability for   beginning after December 15, 2007). Again, it is
uncertain taxes, until the statute of limitations has     critical to recognize that FIN 48 applies not only
22 | The Practical Tax Lawyer                                                                      Summer 2008

to companies whose shares of stock are publicly            quired computations under this “liability method”
traded and therefore are registered with the U.S.          can be quite complex. See FAS 109, ¶¶ 16, 17e,
Securities and Exchange Commission (“SEC”) in              20-21 (deferred tax expense, liability or asset).
reporting “fair value” filings, but also to all entities        FIN 48 applies to “tax positions” contained in
and enterprises that report financial results under        a previously filed tax return or a position that will
GAAP. The scope of FIN 48 extends to all entities          result in a permanent reduction in taxes currently
that use the GAAP method for financial account-            payable or a deferral of income taxes to be paid
ing purposes, including tax-exempt organizations           until a future year. The tax liability for uncertain
as well as pass-through entities.                          tax positions under FIN 48 is not included in the
    In setting forth this new and higher GAAP stan-        general label of deferred taxes. Rather, it must be
dard, FASB required reporting companies to recog-          classified separately from other tax balances based
nize on their financial statements the best estimate       on the expected timing of cash flows to or from tax-
of their tax positions. In abandoning the prior cal-       ing authorities.
culus of whether a tax item “probably, reasonably               The term “position” includes:
possibly, or remotely” would survive IRS review,           • An allocation or shift of income between juris-
FIN 48 establishes a “recognition” or “non-recog-               dictions, e.g., intercompany pricing agreements
nition” approach. For a tax position to be “recog-              under section 482;
nized,” it must have a more-likely-than-not chance         • The characterization of income or a decision
of being sustained on the merits through audit, ad-             to exclude reporting taxable income, e.g., an
ministrative, and judicial review. Once a position              assumed tax-free reorganization transaction
passes this threshold, as further discussed below, the          without the presence of taxable “boot” or gain
expected benefits are subject to a set of measure-              recognition;
ment rules and principles to quantify whether part         • A decision to classify a transaction, entity, or
or all of the benefit is to be recognized.                      other position contained in a tax return as tax
                                                                exempt; and
the fin 48 two-step process                                • A decision not to file a tax return, for example,
     FIN 48 provides a detailed set of principles and           in a foreign jurisdiction based on the assumed
applicable rules in determining how to treat such               correctness that such income is not taxable.
uncertain tax items, referred to as “units of ac-               (This last “position” of non-reporting is fre-
count,” and sets forth a two-step process to recog-             quently of great importance in negotiating a
nize and measure a tax position taken or expected               tax indemnification clause pursuant to a merg-
to be taken on a tax return. FIN 48 is divided into             er or acquisition between a target and acquir-
various categories or segments, including guidance              ing company.)
on the subjects of recognition, derecognition, clas-            If management, upon its review and analysis,
sification, interest and penalties, accounting in in-      determines that the position will more likely than
terim periods, disclosure, and transition. In gener-       not be sustained in the event of audit by the IRS or
al, differences in financial and tax accounting with       judicial review of an IRS challenge, then such po-
respect to uncertain tax items will result in: (i) an      sition can be currently recognized for financial ac-
increase in a liability for income taxes payable or a      counting purposes as well. Still, a prior recognized
reduction of the amount of an anticipated income           position must be charged or reduced by the prob-
tax refund; and/or (ii) a reduction in a deferred tax      able point at which the tax position will be resolved
asset or increase in a deferred tax liability. The re-     between the taxpayer and the IRS or applicable