Accounting for Uncertainty in Income Taxes
In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation Number 48, Accounting for Uncertainty in Income Taxes (FIN 48). FIN 48 not only clarifies but also significantly changes the way companies account for uncertainty in income taxes recognized in their financial statements.
Basic Understanding of FIN 48
Companies often take positions in income tax filings based on tax rules and regulations that are “gray areas” subject to interpretation and judgment. FIN 48 requires companies to evaluate these “gray areas” and estimate the probable outcome of an examination of these positions. If a company determines that an examination would more likely than not result in an unfavorable outcome, it must quantify the amount of exposure and recognize additional expense and liability in its financial statements.
What Should Companies Do Now?
Companies should begin reviewing positions it has taken, or plans to take, in federal and state income tax filings, including decisions not to file returns in certain jurisdictions. They should identify any positions that, based on technical merit, would more likely than not result in an unfavorable outcome. Companies should also estimate the amount of additional income tax expense, penalties and interest that would be incurred.
Identifying Uncertain Tax Positions
During 2006 year-end tax filing and financial statement preparation, companies should consult with their tax professionals and perform a review of their tax positions taken in filings that will still be subject to review by tax authorities. They should also perform a review of tax positions expected to be taken in future filings.
Common instances that may require further analysis:
- Excluding income streams that may bedeemed taxable by taxing authorities
- Making elections to be treated as a pass-through entity (i.e., an S corporation or a limited-liability company) when events have occurred that may render the availability of such elections uncertain
- Asserting that a particular entity restructuring is tax-free when that position may be uncertain
- A decision not to file a tax return in a particular jurisdiction in which such a return might be required to be filed
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Other uncertain tax positions might relate solely to the timing of deductions, such as depreciation methods used and treatment of transactions as like-kind exchanges.
Here are additional key aspects of FIN 48:
- FIN 48 requires accrual of any interest and penalties that would be incurred if the uncertain tax position ultimately was not sustained.
- Liabilities are to be presented separately on the balance sheet, not ascomponents of deferred taxes, and the application of valuation allowances is not permitted.
- Each uncertain tax position is re-assessed at each balance sheet date
- Footnotes to the financial statements must include more detailed disclosure of tax positions than was previously required.
- Liabilities are classified as long term, unless payment is expected within 12 months.
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Summary
FIN 48 will significantly change the manner in which companies account for uncertainty in income taxes. Each entity will need to assess, estimate and quantify their potential exposure, assuming examination of its income tax filings by examiners with full knowledge of all relevant facts. In many instances, these requirements will result in these uncertainties being highlighted in the financial statements in the form of additional disclosure and recognition.
The evaluation and implementation of all the provisions of FIN 48 will require significant involvement by various tax and accounting professionals. Early establishment of a plan to implement the provisions of FIN 48 is essential to the timely and efficient completion of financial statements for fiscal years beginning after December 15, 2006.
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