FIN 48 Accounting for Uncertainty in Income Taxes and Other FAS 109 Topics

FIN 48Accounting for Uncertainty

in Income Taxesand Other FAS 109 Topics

Introductions & Agenda

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Introductions

Glen Kohl, Sr. VP, Tax and TreasuryElectronic Arts

Jeff Sokol, PartnerDeloitte

Rob Terpening, PartnerBDO Seidman LLP

Rusty Thomas, PartnerKPMG

Neil Traubenberg, Vice President, TaxSun Microsystems

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Today’s Agenda

FIN 48 – Overview

FIN 48 – Difficult Issues

FAS 109 Common Errors

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Overview - Reason for Interpretation

Diverse accounting practices in applying Statement 109

Lack of comparability

Evolution of the Standard

Comment Letters

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Scope – What is a Tax Position?

Tax benefit on return filed or expected to be filed • Reduce income tax expense, taxes paid or

payable• Increase tax benefit and receivable, DTA or

refund

Decision not to file a return

Allocation or shift of income between jurisdictions

A characterization of income

A decision to exclude income, or treatment of a transaction, entity or other position as tax exempt

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Step 1 – Initial Recognition of Tax Benefits

Determine “unit of account”• Facts and circumstances in light of all available evidence• Consider:

• Manner in which company prepares and supports tax return• Approach the company anticipates the taxing authority will take

during an examination

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In order to recognize any amount of benefit, for the unit of account, the position must be MLTN of being sustained based solely on the technical merits• The position will be examined • The examiner will have full knowledge of all relevant

information• Evaluation based solely on the technical merits• No offset or aggregation of positions• Conclusion should assume resolution in the court of last resort

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Highly certain tax positions• Clear and unambiguous tax law• Consistent with “will prevail” opinion• Extent of evidence and documentation requires judgment

Administrative practices and precedent• Applies where there has been a technical violation of law

• Expected to be relevant infrequently

• Evidence and documentation

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Step 2 - Measurement

For a tax position that meets the more-likely-than-not recognition threshold…

• Measure initially and subsequently as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with a taxing authority having full knowledge of all relevant information

• Consider the amounts and probabilities of the outcomes that could be realized upon ultimate settlement

• Based on facts, circumstances, and information available at the reporting date

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Illustrative Guidance – Measurement with Information about Approach to Settlement

Scenario• The enterprise has determined that

a tax position resulting in a benefit of $100 qualifies for recognition and accordingly should be measured

• The enterprise has considered the amounts and probabilities of the estimated outcomes.

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Table of Probabilities & Estimated Outcomes

Possible Estimated Outcome

Individual Probability of

Occurring

Cumulative Probability of Occurring

$ 100 5% 5%

$ 80 25% 30%

$ 60 25% 55%

$ 50 20% 75%

$ 40 10% 85%

$ 20 10% 95%

$ 0 5% 100%

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$60 is the largest amount of benefit that is greater than 50% likely of being realized upon settlement

Actually it’s $60 or more that is greater than 50% likely of being realized upon settlement• Probability of $60 itself is only 25%

The “At least” Test: Book the largest number as to which it is more likely than not that the taxpayer will realize at least that number.

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Occurring

Cumulative Probability

of Occurring

$ 100 25% 25%

$ 50 50% 75%

$ 0 25% 100%

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Occurring

Cumulative Probability

of Occurring

$ 100 10% 10%

$ 65 80% 90%

$ 0 10% 100%

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Tax Planning Strategies and Valuation Allowance

Tax planning strategies• Consideration required under FAS 109• Discussed in paragraphs 20-22 of FAS 109 in conjunction

with future realizability of DTA, and corresponding need for (and size of) valuation allowance

• If contemplated as source of future taxable income to support realizability of DTA, must meet recognition and measurement criteria of FIN 48

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Subsequent Recognition, Derecognition, & Measurement

Subsequent Recognition• A tax position which previously did not meet the

recognition threshold gets recognized in the first interim period in which:

• The more-likely-than-not recognition threshold is met by the reporting date, or

• The tax matter is settled through negotiation or litigation, or

• The statute of limitations for the tax position has expired

• A tax matter need not be legally extinguished to subsequently recognize or measure a tax position

• Based on management’s best judgment in view of facts, circumstances, and information available at reporting date

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Subsequent Recognition, Derecognition, & Measurement (continued)

Derecognition

• Derecognize (previously recognized) tax position in the first interim reporting period in which it is no longer more likely than not that the position will be sustained upon examination

• Valuation allowance is not a substitute for derecognition

• Based on management’s best judgment in view of facts, circumstances, and information available at reporting date

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Changes in Judgment

Changes in judgment resulting in subsequent recognition, derecognition, or change in measurement of tax position taken previously

• If initial tax position was taken in prior annual period, recognize change as “discrete” item in period of change

• If initial tax position was taken in prior interim period within same fiscal year, apply APB 28 (Interim Financial Reporting) and FIN 18 (Accounting for Income Taxes in Interim Periods) to take change into account over remaining periods in fiscal year using effective tax rate calculated for interim period

Based on evaluation of new information – not new evaluation, or new interpretation by management, of information that was available in previous period

Analysis must be conducted every reported period

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Interest and Penalties

Interest

• FIN 48 requires accrual if position in tax return is not recognized in financial statements under FIN 48

• When tax law requires interest on underpayment, start recognizing in 1st period it would begin accruing under tax law

• Amount is statutory interest rate times difference between FIN 48 tax position and amount taken in tax return

Penalties

• Recognize when tax position does not meet minimum statutory threshold to avoid payment of penalties

• Recognize in period in which company claims or expects to claim position in tax return

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Classification“Unrecognized tax benefit” concept • Difference between position in tax return and benefit recognized and measured

under FIN 48• Creates liability (or reduces amount refundable or DTA, e.g., NOL)• Represents company’s potential future obligation to taxing authority for tax position

taken in tax return but not recognized pursuant to FIN 48 recognition/measurement guidance

• Again, not actually limited to positions in return but to any tax position

Liability is current or non-current based on expected timing of payment of cash• Current if within one year (or operating cycle, if longer)

Liability recognized is generally not a deferred tax liability• DTL only if it arises from a taxable temporary difference

Interest recognized under FIN 48 – • Accounting policy decision to classify as either income taxes or interest expense

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Disclosures

Accounting policy for classification of interest and penalties

At the end of each annual reporting period:• Tabular “rollforward” of unrecognized tax benefits (“UTBs”) at

beginning and end of period• Total amount of UTBs that, if recognized, would affect the

effective tax rate• Total amount of interest and penalties recognized in the income

statement and balance sheet• Description of tax years that remain subject to examination by

major jurisdictions• Paragraph 21(d) - Positions where it is reasonably possible that

the total amounts of UTBs will significantly increase or decrease within 1 year of reporting date

• Nature of uncertainty• Nature of event that would cause the change• Estimate of range of change, or statement that “can’t estimate”

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Disclosures

Tabular rollforward includes:• Gross amts of increases & decreases in UTBs as a

result of tax positions taken during a prior period• Gross amts of increases & decreases in UTBs as a

result of tax positions taken during the current period• Decreases in UTBs relating to settlements with taxing

authorities• Decreases in UTBs resulting from lapses in statutes of

limitations

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Illustrative Guidance - Tabular Rollforward

(in millions)

Balance at January 1, 2007 $370,000

Additions based on tax positions related to the current year 10,000

Additions for tax positions of prior years 30,000

Reductions for tax positions of prior years (60,000)

Settlements (40,000)

Balance at December 31, 2007 $310,000

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Disclosures

Rollforward/reconciliation “roadmap”?• FIN 48 tabular rollforward requires

disclosures only at aggregate level, not at individual tax position level

• Not by jurisdiction• Not tax position by tax position

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Disclosures

Paragraph 21(d)• Positions where it is reasonably possible that the total

amounts of UTBs will significantly increase or decrease within 12 months of reporting date

• Disclose the nature of uncertainty (i.e. describe tax position)

• Disclose the nature of event that would cause the change• Estimate of range of change, or statement that “can’t

estimate”

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The “Reasonably Possible” Catch-22

It’s reasonably possible that I’ll reverse tax reserves in the next twelve months….

Now, I’ve got you… You may, after all, just need those reserves!

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Disclosures

Paragraph 21(d) – (cont.)

One of the more controversial areas of FIN 48 disclosures – • Define ‘reasonably possible’

• Includes tax positions that are both recognized as well as not yet recognized (due to ‘reasonably possible’ range including probabilities above and below MLTN).

• “Nature of Uncertainty” – how much detail must be disclosed?• Boiler-plate will not be acceptable

• Significant analysis, documentation and judgment• All this must be performed and disclosed in the correct reporting

period. Close scrutiny will be applied to evaluate the quality of the effort and conclusions arrived at in prior periods. Documentation will be an important source of evidence of past analysis and thought process.

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Effective Date and Transition

Effective for FYs beginning after December 15, 2006• e.g., calendar year 2007 companies• Early adoption permitted

(provided company hasn’t yet issued interim financials for that FY)

Apply more-likely-than-not threshold to all income tax positions for all open years

Recognize cumulative effect of applying FIN 48 as an adjustment to the opening balance of retained earnings (or other appropriate components of equity or net assets in the balance sheet)

SAB 74 requires disclosure of impact of FIN 48 on public company financial statements


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Must all tax positions be evaluated for recognition (and correspondingly documented)? • Said differently, are there tax positions, e.g.,

transfer pricing, that lend themselves solely to the measurement test?

• Exposure draft seemed to acknowledge these issues were more valuation questions, where “technical merits” type of issues don’t come into play.

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FIN 48 defines scope to include all tax positions. As a matter of practicality, highly certain tax positions do not need to be analyzed. To what extent should companies document tax positions as being highly-certain tax positions?

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To what extent should FIN 48 be implemented by way of a “bottom-up” inventory approach (i.e., by identifying all material tax positions for each “open” tax year for each jurisdiction) vs. a “top-down approach” (i.e., by starting with identified material uncertain tax positions)?

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As a result of NOLs or tax credits, the statute of limitations related to certain historical periods is often extended to align with the statutes for years in which attributes were utilized. Notwithstanding the scope of all possible open periods, taxing authorities often limit their examination to years defined within a particular cycle. Is it appropriate to rely on this administrative practice to recognize tax benefits in periods prior to the defined cycle?

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How should a company apply the measurement standard to positions likely to be sustained or disallowed entirely (e.g., qualification for section 199 deduction where contract manufacturer relationship exists) – i.e., binary issues?

Is it possible that a position that can be recognized pursuant to the MLTN threshold will be measured such that a benefit of less than 50% is recorded?

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To what extent may a company contemplate “horse trading” – (i.e. using in measurement information about using one position to settle another)? Said differently, can an entity use aggregation of positions or offsetting in measuring a tax position?

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There appears to be inconsistency between paragraph 10 and paragraph 12 about when entities should subsequently recognize, derecognize and measure a tax position. • Paragraph 10 gives three situations which an entity

can use additional information to subsequently recognize the benefits of a tax position including “the tax matter is ultimately settled through negotiation or litigation.”

• Paragraph 12 indicates that a tax position need not be legally extinguished and its resolution need not be certain to subsequently recognize or measure the position.

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Can an entity that has a previously recognized position (i.e., met the more-likely-than not criteria) change the measurement of that position when a tax audit closes and the position was not challenged (notwithstanding the statute of limitation might remain open)? Assume the position was adequately disclosed on the tax return and the subject to IDRs and discussion with the IRS. The case went to appeals and this is not one of the issues as to which there is a proposed adjustment. Of course, there was no closing agreement with respect to that tax position.

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A taxing authority completes an audit and requires an adjustment to a tax position that was not included in the company’s inventory of uncertain tax position. The company is inclined to cave on this issue. Is the addition of that item to the inventory of uncertain tax positions an error or a change in estimate?

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Would an entity with NOLs and a full valuation allowance be required to disclose any amounts in their unrecognized tax benefits roll-forward? For example, an entity has $1M R&D credit carryforward for which $900K can be recorded by applying the principle of FIN 48. Would the entity need to reflect the $100K in the FIN 48 tabular disclosure (notwithstanding the NOL DTA would not be recognized in any event due to valuation allowance assumptions)?

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Consider a scenario where a company owns a hybrid flow-through entity subject to tax in a local jurisdiction in addition to being taxed in the U.S. Does the disclosure requirements of paragraph 21 require that a FIN 48 liability be disclosed to the extent that a local country exposure item, notwithstanding that any increased local tax expense would produce a corresponding US foreign tax credit (economically mitigating the risk item – assuming no U.S. foreign tax credit limitations)?

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Will entities be required to disclose the fact that the statute of limitations is going to expire in the next twelve months which will create a significant change?

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Under FAS 123(R), there is a requirement that the tax benefit associated with the excess tax deduction be realized by reducing taxes payable. Since FIN 48 requires that a contingent tax payable be accrued, it would appear that it should be offset by the excess tax deductions not otherwise recognized (so the entry is to debit current tax provision and credit APIC).

If the tax position is not later challenged or if the taxpayer prevails, then the APIC was never realized. Should it then be reversed so that the provision can be credited?

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Can tax positions that are not individually significant be evaluated in the aggregate when the aggregated amount is material? Consider, for example, transfer pricing for commission agent or stripped buy/sell subsidiaries, or intercompany debt financing with operating subsidiaries.

FAS 109 – Common Errors

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Tax Accounting for Business Comb. – Foreign Subsidiaries of Target

Same general tax accounting principles apply; deferred tax reporting for book/tax basis differences of inside basis assets/liabilities

Must apply “push down” accounting concepts, even if purchase accounting adjustments maintained in consolidation

In purchase accounting DTA/DTL establishment, imperative that appropriate jurisdictional rates be respected

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Jurisdictional Rate Example - Cost Sharing Structure in Target –

Nontaxable business combination

Acquiror (A) has a global effective rate of 30% and a US effective tax rate of 40%

Target has a mature cost sharing structure – 50% non-US participant in Singapore

Target (B) has 25% overall tax rate (US 40%, 10% blended non-US rate; 0% rate in Caymans)

Purchase accounting – only identifiable intangible is product rights/IP of $40M

WHAT RATE TO USE FOR THE PURCHASE ACCOUNTING DTL?

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Interplay of APB23 and CTA

For affiliates reporting in non-US$ FC, currency translation adjustments (CTA) are a component of OCI

If all or a portion of unremitted earnings are not indefinitely reinvested under APB23, deferred tax reporting required on proportionate amount of CTA• Recorded as a component of OCI

Often overlooked, or complicated computations can be prone to errors

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Tax Effect of CTA on Unremitted Earnings

CFC

USP

1,000€ PBT

200 € Tax

US Tax DTL Entries• (No APB 23 Reinvestment)

Year 1: 1€ = 1$• Dr. DTA (FTC) 200• Dr. Tax Provision 150• Cr. DTL 350

Year 2: 1€ = 1.2$• Dr. OCI 70• Cr. DTL 70

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Valuation Allowance- Indefinite Lived Intangibles

Deferred Tax Liabilities

• FAS 142, Goodwill and Other Intangible Assets, stipulates that indefinite-lived intangibles and goodwill are not amortized

• FAS 109 requires recognition of deferred tax liabilities and assets for temporary differences related to intangibles and goodwill and the tax-deductible portion of goodwill

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Valuation Allowance- Indefinite Lived Intangibles

“Because indefinite-lived intangible assets and goodwill are not amortized, the related deferred tax liabilities will not reverse until some indeterminable future period (e.g., when the financial asset is impaired or disposed of)

Due to the indeterminable reversal period of temporary differences related to indefinite-lived intangible assets and goodwill, such reversals normally should not be considered a source of future taxable income when assessing the realizability of deferred tax assets

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Assumed Stock Options from Acquisition - Vested

NQSOs; deductible non-US• Purchase accounting – FV

in purchase price

• No DTA (EITF 00-23)

• Tax accounting – tax effect of section 83 deduction up to fair value reduces purchase price (excess to APIC)

ISOs/ESPPs, nonded non-US• Purchase accounting – FV

in purchase price

• No DTA

• Tax – deductible if ISO or ESPP DD

• Tax accounting – tax effect of section 421(b) deduction to APIC

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Assumed Stock Options from Acquisition – Unvested

NQSOs, deductible non-US• Purchase accounting – FV

in purchase price • Fair value expensed over

vesting period; DTA established (tax expense benefit)

• Tax accounting – tax effect of section 83 deduction applied against DTA, excess tax benefit to APIC; any shortfall to APIC pool, then to tax expense

ISOs/ESPPs, nonded non-US• Purchase accounting – FV

in purchase price

• Fair value expensed over vesting period; permanent difference

• Tax accounting at time of DD – section 421 deduction yields tax expense benefit up to value of stock-based comp charge; excess to APIC

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ETR vs. DiscreteDiscrete Accrual to return adjustment to the tax accounts for the prior year return

Rate Adjustment to the current period rate related to information learned from prior year return

Discrete Adjustment to tax contingency reserve specific to prior tax years

Rate Accrual of tax contingency reserve related to current year items

Rate Accrual of interest (for the current year) related to prior year tax contingencies

Discrete Accrual of penalty for prior year tax contingency

Discrete/Rate Adjustment of current year rate to incorporate changes in law or rate – discrete to period that includes enactment, accrued by application of new ETR to year-to-date pre-tax income

Rate Valuation allowance required for deferred tax assets arising in the current year

Discrete Valuation allowance required for deferred tax assets existing as of the beginning of the annual period

Rate Valuation allowance release related to expected use of previously valued attributes based on current year income (assuming the current year income allowing the use of the valuation allowance is continuing operations in nature)

Discrete Valuation allowance release related to expected use of previously valued attributes based on current year income other than continuing operations (discrete tied to recognition of income allowing release of valuation allowance)

Discrete Valuation allowance release related to expected use of previously valued attributes in future periods

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Consider Tax Effects of Certain Items

State tax is deductible• Current deduction• Deferred tax effect

Interest is deductible

Foreign tax may be creditable

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ARB 51 – Intercompany Transfer of Assets

Under ARB51, tax expense by selling affiliate on intercompany transfers should be deferred• Deferred until asset leaves consolidate group (or is

depreciated, amortized, or impaired)

Treated as prepaid tax, not deferred tax

Applicable not only to inventory transfers, but also intangibles (e.g., buy-in payments)• Note applicability to post-acquisition buy-ins; if buy-in

encompasses goodwill, tax expense deferred until impairment

ARB51 expected to be changed in ’07 in FASB Short-Term Convergence project

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Classification of Valuation Allowance

Pre-Val. Allow

Par. 41Allocation

FinalClassification

Reserves 1,000 1,000

Valuation Allowance (600) (600)

Subtotal - Current DTAs/DTLs (600) 400

NOLs 4,000 4,000

Depreciation (2,000) (2,000)

Valuation Allowance (2,400)

Subtotal - Noncurrent DTAs/DTLs 2,000 (2,400) (400)

Total DTAs/DTLs 3,000 (3,000) 0

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Subsequent Release of Valuation Allowance

Valuation Allowance established at time of combinations

Tax benefits recognized subsequent to the acquisition are applied, in order:• Reduce to zero any goodwill related to the acquisition;• Reduce to zero other non-current intangible assets

related to the acquisition;• Reduce income tax expense

(Note: FAS 141R ED proposes change)

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Ordering of Recognition

Generally must be specifically identified and recognized bases on tax return ordering

If cannot be identified, then prorate

Tax benefit substitution rule (Paragraph 244)

Contrast with EITF D-32 relating to stock option windfall deductions

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Paragraph 244 ExampleFinancial Income Taxable Income

Year 1: Income (loss) from operations $(4,000) $(4,000)

Year 2: Income (loss) from operations $0 $0

Taxable gain on sale 2,500

Taxable income before NOL 2,500

NOL from year 1 (4,000)

Taxable Income $0

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Tax Reporting Issues with Non-US Subsidiaries

Recording changes in deferred taxes for statutory rate changes in year of enactmentImproper netting of jurisdictional deferred tax assets and liabilitiesDisclosure issues around non-US gross deferreds and valuation allowancesAPB23 deferred tax liabilities where not permanently reinvested• Substantiation of E&P and taxes paid pools for CFCs• Adjustment for tax audits - both local and IRS (correlative adjs)• Consideration of locally reported “inside basis” DTLs in deemed

paid credit computation

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Intraperiod Allocation – Paragraph 140” With” ” Without” Par. 35 Par. 140

Sales 1,000,000 1,000,000 1,000,000

Expense (1,600,000) (1,600,000) (1,600,000)

Income Before Taxes (600,000) (600,000)

(assumes valuation allowance required)

Tax Provision 40,000

Net Income (6,000,000) (6,000,000) (560,000)

Other Comprehensive Income - FAS 115 Gaines

100,000 100,000

OCI Tax Effect (40,000)

Comprehensive Income (500,000) (600,000) (500,000)

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APB 23 Background

Not an election

Exception applies if the specific facts and circumstances warrant

Based on a company’s ability and intent to control the reversal of a taxable temporary difference

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APB 23 – “Ability” Requirement

Management representation must be supported by the facts and circumstances (APB 23 ¶ 8)• Financial needs of parent, and of the sub• Remittance restrictions (legal, foreign jurisdiction)• Tax consequences of the remittance

Changes in facts and circumstances permit companies to justify a change in their APB 23 position with respect to applying the indefinite reversal criteria.

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APB 23: ManagementRepresentation

Evidence of specific plans for reinvestment which demonstrate that remittance of the earnings will be postponed indefinitely• Past experience considered• Plans for future operations and remittances considered• Indefinite (5-7 years is common)

Can make different representations for different foreign subsidiaries

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APB 23 - Documentation

APB 23 contains a presumption that all earnings will be distributed to the ultimate corporate shareholder unless “clear plans” exist that demonstrate reinvestment

• Support should be documented (auditors, shareholders, SEC)

• Compliance With Sarbanes – Oxley Section 404 requirements

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APB 23 Disclosure

The following information is disclosed whenever a deferred tax liability is not recognized:• A description of the types of temporary differences for

which a deferred tax liability has not been recognized and the types of events that would cause those temporary differences to become taxable

• The cumulative amount of each type of temporary difference

• The amount of unrecognized deferred tax liability for temporary differences related to investments in foreign subsidiaries or a statement that determination is not practicable

Documents

FIN 48 Accounting for Uncertainty in Income Taxes and Other FAS 109 Topics