FIN 48 Creates New Complexity for Multistate Companies

January 26, 2007 Income Taxes

At the state tax level, the Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes --an Interpretation of FASB Statement No. 109, creates new complications for tax departments, particularly in states where a company has taken a nonfiling position. Recently, Michael A. Jacobs, counsel with Dechert LLP in Philadelphia, conducted a teleconference on state income tax nexus and FIN 48. In this interview, BNA talks with Mr. Jacobs about some of his conclusions and recommendations.

FIN 48 Creates New Complexity for Multistate Companies Assessing Viability of `Uncertain' State Income Tax Positions

By Dolores W. Gregory, BNA Legal Editor

BNA: What does it mean to account for uncertainty in income taxes?

JACOBS: For financial accounting purposes, a company needs to record its tax expense. That amount can be different from the amount reported on the company's tax returns. One difference is attributable to tax positions that are taken on a tax return and which the taxing authority might disagree with --that is, the positions that are uncertain. As we're all aware, income tax issues are full of uncertainty, particularly in the state area. For example, in the income tax area, you're dealing with different states that have different standards of what constitutes doing business, overlaid with federal Due Process and Commerce Clause rules that have been applied differently by different state courts. In many cases, two practitioners presented with the same set of facts will reach differing conclusions with respect to the income tax consequences. Dealing with this type of uncertainty presents a challenge in the financial accounting area, where the goal is to present investors and the public with data that is both accurate and easily compared with the data presented by other companies. FIN 48 represents an effort by the FASB to impose some structure on the way that companies analyze and account for uncertain income tax positions. However, I don't think it is possible to completely eliminate subjectivity from the process of accounting for income taxes. Even under FIN 48 there will be inconsistencies in the way different companies handle similar positions.

BNA: What is the scope of FIN 48?

JACOBS: FIN 48 is effective for fiscal years that begin after Dec. 15, 2006. For calendar year companies, the first financial statements to be affected will be those for the first quarter of 2007. However, companies may need to disclose an estimate of FIN 48's effect on financial statements for periods before the first quarter of 2007. It is also important to note that FIN 48 covers any income tax positions for which the statute of limitations for assessment remains open, not just the new positions reflected on financial statements for periods after th FIN 48 effective date. For nonfiling positions, in most cases, the statute of limitations has not begun to run. As a result, in the nonfiling context, you could be applying FIN 48 to positions taken in some very old periods.

BNA: FIN 48 creates a "more likely than not" standard for evaluating a tax position. What does that mean?

JACOBS: "More likely than not" means more than 50 percent. FIN 48 imposes a "more likely than not" standard for determining whether a company can book any tax benefit associated with a position. A company may book a tax benefit associated with a position only if there is greater than 50 percent chance that the position will be sustained, assuming the position is examined on audit with full knowledge of all the relevant facts, and the examination results are appealed through all of the applicable administrative and judicial processes.

BNA: And if you can't meet that threshold?

JACOBS: For book purposes, you may only record the benefit of an income position if you can get over that 50 percent threshold. Once you get over that threshold, you move on to the measurement stage --to figure out the greatest amount of tax benefit that is more likely than not to be sustained.

BNA: So what you claim on your tax return and what you report on the financial statements are not necessarily going to be the same figure?

JACOBS: Yes. They can be different amounts. For instance, when a company files a return and claims a deduction, there is a certain benefit associated with that deduction. You might conclude that the deduction is more likely than not to be sustained, but at the same time, you could also conclude that on settlement you might not be allowed the full amount of the claimed deduction. In the measurement stage, you have to determine what is the greatest amount of tax benefit that is more likely than not to be realized. You might conclude that it is only 60 percent of the amount claimed on the tax return, because you've had experience with this issue before and you know that this is where the state or the federal government typically settles disputes involving this particular issue.

BNA: How far apart can the financials be from the tax return?

JACOBS: The taxes a company records on its return and the amount of its tax liability for book purposes could be quite different. For instance, the company might be comfortable taking a position on its return that it has concluded is supported by substantial authority, even though it has also concluded that there is a less than a 50 percent likelihood that the position would be sustained by the state on examination. In that case, the company may recognize the full benefit of the position on its return and recognize none of the benefit in its financial statements.

BNA: So essentially you could be very aggressive in terms of the tax filing, but FIN 48 asks you to be more conservative when it comes to calculating the benefit for your financial statements?

Companies could shy away from taking legitimate, but aggressive, positions on their returns to avoid the need to explain the difference between the amount of taxes reported on the books and actual taxes reported to the taxing authorities.

JACOBS: Yes. Also, don't forget that FIN 48 does not allow a company to take into account the fact that a position on a return probably won't be picked up on audit. This will further exaggerate the divergence between the amount of income taxes that a company may report for financial accounting purposes and the amount of taxes that it actually expects to pay. It is possible that we are going to see the financial accounting reporting of income tax positions driving the actual tax reporting of those positions going forward. Companies could shy away from taking legitimate, but aggressive, positions on their returns to avoid the need to explain the difference between the amount of taxes reported on the books and actual taxes reported to the taxing authorities. However, companies that take such an approach might not be acting in the long-term best interest of shareholders.

BNA: It sounds as if, because of FIN 48 tax departments will be under more pressure to align the tax returns with the financial statements.

JACOBS: Yes. I am concerned that will be one of the effects of FIN 48. And let's not forget that the financial statements we are talking about are public documents. Taken together with the relatively new schedule M-3, state and federal authorities will be able to focus on large differences between the reported tax and the book tax amount. This may prompt them to request copies of the work papers that back up the tax accrual number for book purposes. A lot of companies are concerned that taxing authorities could be planning to use the tax accrual work papers as an audit tool, to find issues they had not discovered before.

BNA: What would you look at to figure out the probability of a position being sustained?

JACOBS: You would look to the same types of authorities that you would typically look at in evaluating a position. For example, statutes, regulations, legislative history, cases, and rulings. You can also take into account widely understood administrative practices, to the extent they might contradict the conclusions you might otherwise reach from looking at the "black letter" law. The one thing that you cannot look at is the value a position might have as part of a negotiated settlement. In the evaluation phase, you must assume that an issue will be decided on its merits. However, once you're in the measurement phase of FIN 48, you can take into account possible settlement. So if you know how a state is settling an issue with other taxpayers, or you have prior experience with the same company, you can take that into account.

BNA: In your presentation, you mention that nexus positions can create perpetual unrecognized tax benefits. What do you mean by that?

JACOBS: If you don't file a return, in most states, the statute of limitations for assessment has not begun to run. So, as long as you continue to take the nonfiling position and don't do anything proactive to clear up the potential liability associated with the nonfiling position --assuming that you determine that the nonfiling position is not more likely than not to be sustained --the liability for that position is going to stay on your books forever. Compare that with a position on an apportionment issue, for example. In the case of the apportionment issue, you filed a return, but you're not sure whether the position is more likely than not to be sustained. In that case, you may book a liability for the position, but the statute of limitations for assessment of additional tax for that year is going to expire at a certain point. Once that statute of limitations has expired, then you know your position is more likely than not to be sustained.

BNA: Because the state can't come after you.

JACOBS: They can't assess the tax associated with the position any more. And you can book the tax benefits associated with the position at that point, even though it might not have been a position that was "more likely than not" to be sustained on examination. But that won't happen with a nonfiling position. In the past, for accounting purposes, companies applied a rule of reason. They'd say, "we're talking 20 years ago, in a state where I have very little or no audit profile. I am not going to book a liability for that." FIN 48 doesn't really allow for that, unless the rule of reason reflects a widely understood administrative practice. This is going to cause a lot of heartburn for companies, especially when you're talking about situations where the companies will need to look far back in time and determine what their exposure would be for a period or jurisdiction, since there might not be a lot of surviving documentation or a lot of people who were around at the time to flesh out the facts.

BNA: Are there other aspects of state taxes that will be particularly difficult as a result of FIN 48.

JACOBS: Apportionment. Again, it's an area where you've got a lot of different state rules that might be similar, but not identical. Also, you've got an overlay of some constitutional authority that is not necessarily consistently applied by all the states. For instance, in New Jersey you've got the whole issue of New Jersey's throwout rule and whether it's constitutional, and if so, how it would be applied to certain types of companies. And then you have more general apportionment issues. For example, determining whether receipts from activities other than sales of tangible personal property are included in the sales apportionment factor numerator is an area of great uncertainty under the laws of many states. My impression is that companies have not paid a lot of attention to these sales factor issues in the past. Under FIN 48 companies will have to examine the methodology they use for developing their sales factor a lot more closely. This examination could cut both ways. In my experience, a lot of companies include receipts in their sales factor numerators that probably don't belong there, based on the applicable statute or regulations.

BNA: They adopt a one-size-fits-all approach that puts them in the position of being more conservative than they need to be in certain states?

JACOBS: Exactly.

BNA: Do you think FIN 48 will motivate companies to seek out voluntary compliance agreements where they otherwise might not have?

JACOBS: This will definitely be the case for companies with nonfiling positions. In the past, a company would generally take into account audit risk in determining whether it needed to book a liability for a nonfiling position. Under FIN 48 that is no longer allowed. As a result, a company with a nonfiling exposure is going to end up booking a liability for taxes associated with a nonfiling position, even though the company might conclude that the taxes won't ever need to be paid. In this type of situation, the company might determine that it is better off entering into a voluntary compliance deal with the state where it agrees to file returns and pay taxes for a set number of years. The amount paid under this type of deal will often be only a small fraction of the liability that the company would otherwise need to book. At the same time, this type of deal may be very attractive to the state, because if a company comes forward voluntarily, the state is collecting taxes from a nonfiling company that it may never have identified. Essentially, the state will typically give a company some value for audit risk, because this is "found money." However, I don't want to create the impression that for every company FIN 48 will increase the amount of tax liability they need to record on their books. For corporations that have exposures for nonfiling positions, I think FIN 48 is likely to increase the amount of tax liabilities recorded for book purposes. However, for many companies FIN 48 might result in a decrease in the amount of tax liability recorded for book purposes. Another thing to realize is that just because a tax position is uncertain and you're not able to reach a "more likely than not" conclusion with respect to the merits of a position today, that doesn't mean it will always be the case.

BNA: Because eventually the statute of limitations will run?

JACOBS: That's one reason. But there are a lot of things a company can do to bring its uncertain positions to the fore and get a degree of certainty that will allow them to evaluate the positions under FIN 48. Companies can get more certainty by seeking rulings, litigating cases, and filing Freedom of Information Act (FOIA) requests. These approaches may be particularly fruitful when dealing with state income tax positions. States often publish only a small fraction of their administrative guidance. In many cases, a FOIA request can uncover a treasure trove of documentation about how a certain position has been treated.

BNA: Getting back to the "more likely than not to be sustained" standard. Exactly how do you determine that? Aren't you being asked to prognosticate a bit?

JACOBS: It's not that different from what lawyers were doing even before FIN 48. You're often asked to give opinions on certain positions and how you think they'd be viewed by a state administrative body or a court, so you're always involved in that process of prognosticating. There are certain authorities that will form the basis of your analysis --law, regulations, and other published authorities --and often, based on those alone, you can reach a conclusion that probably 90 percent of practitioners would agree with. The tough issues --the things that are really going to cause problems under FIN 48 are that other 10 percent, where you can't say, just based on authorities that are available, what position is more likely than not to prevail.

BNA: How would you handle that other 10 percent?

JACOBS: You have to dig harder, look at the legislative history, see how similar issues have been handled. Sometimes you may need to do an FOIA request. In the end, no matter how much information you have, there's a degree of judgment involved. That's the untold secret of FIN 48. Although it was intended to impose some uniformity on the process of accounting for income tax positions, there's a big degree of subjectivity that can't be removed from the process.

BNA: Such as in the measurement phase of the analysis?

JACOBS: This is another situation where the consistency that was supposed to be imposed by FIN 48 is not all that was advertised. When you're dealing with a position where there are only two possible outcomes --for example, either you get the full deduction or you get no deduction --then measurement is easy. You know if the position is sustained, you'll get 100 percent of the benefit. But in many cases, you're dealing with positions with more than two possible outcomes.

BNA: What do you do in that case?

JACOBS: What is suggested in FIN 48 is that you put together a matrix, listing all the potential outcomes and the associated tax benefits. Then you figure the probability of achieving each potential outcome. Once you put the matrix together, you take a cumulative probability approach. Starting with the result that generates the greatest tax benefit and working down to the result that produces the least tax benefit, add up the probabilities. As soon as you reach the outcome where the sum of those probabilities exceeds 50 percent, that's the amount of tax benefit you can book. It looks wonderfully precise in the examples in FIN 48. But in reality, I can't think of very many situations where it would work that way. I might be able to narrow the potential outcomes down to four or five possibilities. However, in order to associate a particular percentage likelihood with each outcome --that's going to involve some pretty subjective determinations.

BNA: You also emphasized during your teleconference that this calculation is not just a once and done task. You've got to be constantly reassessing your tax positions.

JACOBS: That's right. In every quarter you must review all the new positions that have arisen in that quarter and reevaluate all of the positions that were evaluated in previous quarters. You need to reevaluate these old positions, because, in some cases, your evaluation or measurement determinations could change. For instance, if there is new information available, you may be able to get to a "more likely than not position" where you couldn't in the past. I imagine, over time, that companies are going to develop quite a large inventory of positions. Most positions, however, are fairly certain, and the evaluation and measurement determinations for those positions are unlikely to change going forward. Probably the focus will be on a fraction of positions, the ones that are truly uncertain. Still, it will be a lot of work to keep track of all the positions.

BNA: Is it fair to say FIN 48 further contributes to complexity?

JACOBS: I think this is going to create a large extra workload for tax departments in companies and a lot of work for outside advisers as well. This extra workload will be an issue in the federal and international tax areas, but my impression is, it will be a particularly hot issue in state taxation, simply because many companies are already dealing with a multitude of jurisdictions with limited staffing. And to be honest, many companies have not traditionally given the positions they were taking on state tax returns the same degree of scrutiny that they gave to positions taken on their federal return.

BNA: And now they're going to.

JACOBS: Yes. The structured analysis imposed by FIN 48 is likely to cause companies to apply much more scrutiny to positions taken on their returns, because from day one, companies will need to consider how they're going to handle those positions under FIN 48.