Accounting for Income Tax Uncertainties & Common Pitfalls

Katherine D. Morris, CPAAugust 2010

www.smith-howard.com

Uncertainty in Income Taxes –Agenda

• GuidanceGuidance• Reviewing UTP’s • Documentation• Documentation• Reporting & Disclosures

P d IRS R ti• Proposed IRS Reporting• Potential Issues• Common Pitfalls in ASC 740

Solitary facts…

Accounting for I TIncome Tax

Uncertainties

ASC 450 (FAS 5) Hi t i l G idHistorical Guidance

• Evaluate likelihood of future events• Evaluate likelihood of future events– Probable

- Likely to occur – Reasonably possible

- More than remote but less than probable p

– Remote- Slight

• Guidance does not quantify thresholds• Guidance does not quantify thresholds• ASC 450 (fka FAS 5) continues to be

applicable for the evaluation of non-income tax reserves

Accounting for Income Tax U i i Wh i i d?Uncertainties: What is required?

• Requires all material income tax positions for all open tax years to be reviewed

How: 2-Step ProcessHow: 2 Step Process

•Step 1: Recognition:Step 1: Recognition:–A tax position must be

“more likely than not” (MLTN) of being sustained

More likely than not?

(MLTN) of being sustained in an audit to record the benefit of the positionAssume you will be audited–Assume you will be audited

–If MLTN standard is not met, the item is an “uncertain tax position”uncertain tax position

How: 2-Step ProcessHow: 2 Step Process

•Step 2: Measurement:Step 2: Measurement:–If a position is recognizable, the amount recognized must be the

largest amount of tax benefit that is greater than 50% likely of being realizedg

P ibl O t C l ti

What probable outcome > 50%?Possible Outcome  Cumulative 

Probability$ 100 5%$ %$ 60 55%$ 20 95%

Scope – What is a T P iti ?Tax Position?

• Tax benefit on return filed or expected to be filed p• Decision not to file a return• Allocation or shift income

C f• Characterization of income• Decision to exclude income

Recognition Threshold: “More Likely Than Not”More Likely Than Not

• Greater than 50%• Greater than 50%– Matter of judgment

B d f t d i t– Based on facts and circumstances– Consider all available evidence

Recognition Threshold: “M Lik l Th N t”“More Likely Than Not”

• Technical merits of a tax position areTechnical merits of a tax position are derived from sources of authority– Legislation & statutesLegislation & statutes– Legislative intent– Regulations, rulings, case law

When?• Effective for US GAAP financials

– Nonpublic Companies: p p• Periods beginning after December

15, 2008• Effective for 2009 calendar yearEffective for 2009 calendar year

companies

Public Companies:– Public Companies:• Periods beginning after December

15, 2006

Uncertain Tax Positions ASC 740-10 P Th h E titiPass Through Entities

• ASU 2009-06 provides: p– Guidance for pass-through entities and tax-exempt

not-for-profit entitiesDisclosure modifications for non public entities– Disclosure modifications for non-public entities

• Clarifies that all entities are subject to ASC 740– Even if the only tax position in question is the entity’sEven if the only tax position in question is the entity s

tax status.• Technical merit required

– Management needs to determine whether the laws and regulations of the taxing jurisdictions attribute income taxes to the entity or its owner.

Now Applies toP th h E titiPass-through Entities

• Attribution to the entityAttribution to the entity– Amounts that may be due are classified as

income taxes and subject to ASC 740 for theincome taxes and subject to ASC 740 for the entity.

• Attribution to ownersAttribution to owners– Amounts due to or from the taxing jurisdiction

are classified as transactions with ownersare classified as transactions with owners.

Now Applies to Pass-through E titiEntities

• Critical issues:Critical issues: – Is the pass-through treated as a valid

partnership or s-corporation in the jurisdictionpartnership or s corporation in the jurisdiction for which they must file?

– Would the technical merits of the jurisdictionWould the technical merits of the jurisdiction indicate that income taxes are attributable to the owner(s) or the pass-through entity?

Now Applies to S-corporationsNow Applies to S corporations

• Considerations– Does the S-corporation have a valid S-

Corporation election? Have the distributions historically been in– Have the distributions historically been in proportion with ownership?

– Is the S-corporation properly tracking the disposal of assets with built in gains?of assets with built-in-gains?

– Is the S-corporation filing in all required states and paying income taxes that are not passed to

?owners?– Have foreign taxes on their investments been

considered?

Now Applies to Non-profitsNow Applies to Non profits

• Considerations: Non-Profits– Did the non-profit have a valid tax exempt

application approved by the IRS?Is the non profit entity meeting the requirements– Is the non-profit entity meeting the requirements of its tax exempt status?

– Have articles been submitted to the IRS for changes in the business over the years i e ischanges in the business over the years—i.e., is tax-exempt status current?

– Does the non-profit entity have any unrelated b i i t i l t d?business income not previously reported?

– Does the non-profit have partnership or foreign investments?

The bottom line…

Reporting & Disclosures

Reporting: TransitionReporting: Transition • Implementation:p

– Record cumulative effect as an adjustment to the opening balance of retained earnings

• Include:Include:– Tax liability upon adoption– Refund claims not previously recorded

Interest and penalties on UTPs– Interest and penalties on UTPs• Exclude:

– Items that would not be recognized in earnings g g• e.g., business combination adjustments to goodwill

– Timing differences fully offset by changes in DTA & DTL

Reporting: InterestReporting: Interest

• Interest– ASC 740 (FIN 48) requires accrual if position in

tax return is not recognized in financial statements under ASC 740 (FIN 48)statements under ASC 740 (FIN 48)

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

– Amount is statutory interest rate times difference between ASC 740 (FIN 48) tax position and amount taken in tax return

Reporting: PenaltiesReporting: Penalties

• PenaltiesPenalties– Recognize when tax position does not meet

minimum statutory threshold to avoid paymentminimum statutory threshold to avoid payment of penalties

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

DisclosuresDisclosures

• Accounting policy for classification ofAccounting policy for classification of interest and penalties

• Public Companies Only:• Public Companies Only:• Tabular “rollforward”• Total amount of UTBs that affect the effective tax• Total amount of UTBs that affect the effective tax

rateInterest and penalties• Description of open tax years

Required Disclosures –N bli C iNonpublic Companies

– Total interest & penaltiesTotal interest & penalties• ASC Section 740-10-50-15(c)

– 12-month look forward12 month look forward• Reasonably possible of occurring in the next 12

months– ASC Section 740-10-50-15(d)

– Open statutesASC Section 740 10 50 15(e)– ASC Section 740-10-50-15(e)

Hindsight: Error versus Change in E i

ASC Master Glossary

EstimateASC Master Glossary

• Change in estimate / change in facts / change in judgment: j g

– results from “new information”• Error:

– results from…“mathematical mistakes, mistakes in the application of accounting principles or oversight or misuse ofof accounting principles, or oversight or misuse of facts that existed at the time the financial statements were prepared”

PricewaterhouseCoopersSlide 23 July 2010Accounting For Income Taxes

Hindsight: Error versus Estimate

Considerations in Tax

Hindsight: Error versus Estimate

Considerations in Tax• New information; or

R bl k bl i f ti• Reasonably knowable information

• Ask / document:– Was it a fact that was known or should have

been known?

PricewaterhouseCoopersSlide 24 July 2010Accounting For Income Taxes

IRS Announcement 2010-9 and 2010-172010 17

Proposed Reporting of Uncertain T P itiTax Positions

Uncertain Tax Positions: Proposed IRS ReportingProposed IRS Reporting

January 26, 2010 IRS dropsJanuary 26, 2010 IRS drops a bomb…IRS Announcement 2010-9:• Comment period ended June

1, 2010.• Proposes UTP reporting,Proposes UTP reporting,

effective for 2010 tax returns.Certain Business Taxpayers

ill b i d t twill be required to report uncertain tax positions (UTP) in tax returns(UTP) in tax returns.

Lost in the wilderness…

Potential Issues

Consider Changes in Accounting P i i lPrinciple

Guidance:Guidance: – Accounting methods or principles may be

changed for book purposes in the financial t t tstatements.

– The changes may not be considered for tax reporting purposes because a tax accountingreporting purposes because a tax accounting method change was not requested but must be considered for the financials.A b k/t diff d th t d l– A book/tax difference and the expected reversal of the item must be computed for computing interest & penalties.

ASC 740 and ASC 740‐10Page 29

A dit S ttl tAudit Settlement• IssueIssue

– When is an uncertain tax position “settled”?• Application• Application

– FSP FIN 48-1, “Definition of Settlement in FASB Interpretation No 48 ” issued May 2007FASB Interpretation No. 48, issued May 2007

A dit S ttl tAudit Settlement• Guidance

– Position must be effectively settled and meet 3 conditions

1 Completion of exam;1. Completion of exam;2. Company does not intend to appeal/litigate; and3. Remote likelihood that taxing authority would

/examine/re-examine tax position

• Take AwayEven though FIN 48 1 was issued in 2007– Even though FIN 48-1 was issued in 2007, uncertainty and disputes around “settlement” still exists; therefore, support tax positions taken

“Settlement” is Limited to ExaminedSettlement is Limited to Examined Return Year(s)

• IssueIssue– Company completes an exam and agent fails

to identify an uncertain tax position in thatto identify an uncertain tax position in that year’s tax return; company settles year under exam

• Take Away– Settlement provides no new evidence aboutSettlement provides no new evidence about

the technical merits of similar tax positions in other years’ tax returns

Valuation Allowance on DTAs Not aValuation Allowance on DTAs Not a Substitute for Analysis

• GuidanceGuidance– DTAs should be established for all deductible

temporary differences, NOLs and Creditsp y ,– Record DTAs gross; then consider need for VA– VA may be required on a specific DTA if future y

realization is in doubt due• Expiration of a tax attribute (e.g., an NOL, tax credit)

I ffi i t f t t bl i i ti l• Insufficient future taxable income in a particular jurisdiction

Uncertain Tax Positions ASC 740-10 Related EntitiesRelated Entities

• Guidance:Guidance:– Consolidated or combined financial statements are to

include all tax positions of each entity within the group that is subject to income taxes or that has taxable incomeis subject to income taxes or that has taxable income assigned to it from a pass-through entity

• Example:A must include ASC 740 10 issues– A must include ASC 740-10 issuesof B, even though A is a pass-through entity

A100%

Consolidated Financials

BB

G D f d T A tGross up Deferred Tax Assets• GuidanceGuidance

– Gross-up deferreds when have a full VA and uncertain tax liabilitiesuncertain tax liabilities

• Federal exposures and state benefits • Transfer pricing exposures and benefits from p g p

different jurisdictions

No Netting of Cross JurisdictionalNo Netting of Cross Jurisdictional Tax Issues

• GuidanceGuidance – Multinational companies should not use a

historically-based blended foreign tax ratehistorically based blended foreign tax rate• Required to calculate UTPs based on each

jurisdiction and the rate in existence when benefit was taken or will be taken

• Example: R&D labs may be located in one country; manufacturing– R&D labs may be located in one country; manufacturing plants in other countries

– Company may file in one jurisdiction but not another: benefits cannot offset exposuresbenefits cannot offset exposures

R i B fitRecognize Benefits• GuidanceGuidance

– ASC 740-10 also applies to refund claims – Recognize and measure benefits using theRecognize and measure benefits using the

ASC 740-10 (fka FIN 48) criteria, not as a contingent gain under ASC 450 (fka FAS 5)

• Take Away– Consider the impact of liabilities and refund

l i t lclaims separately• Retained earnings at the time of adoption• Income tax benefit in future periodsIncome tax benefit in future periods

Consider Tax Law ChangesConsider Tax Law Changes

• Guidance:Guidance: – Deferred tax liabilities and assets shall

be adjusted for the effect of a change in tax laws or rates (ASC 740-10-35-4) [by jurisdiction]The effect of a change in tax laws or– The effect of a change in tax laws or rates should be included in income from continuing operations for the period that g p pincludes the enactment date (ASC 740-10-45-15 )

U S bj t M tt E tUse Subject Matter Experts• IssueIssue

– A blended federal based tax rate is used for all issuesall issues

• GuidanceASC 740 10 requires taxpayers to look at all– ASC 740-10 requires taxpayers to look at all tax positions on a jurisdictional level

Use Subject Matter ExpertsUse Subject Matter Experts

• Examples of Subject Matter Experts:Examples of Subject Matter Experts:

– Federal– IRS practice & procedures– International – domestic treatment– Foreign jurisdictions tax specialists– Transfer pricing

R&D credit– R&D credit– SALT– Compensation & benefitsCompensation & benefits

ASC 740ASC 740

Top 10Top 10Common Pitfalls

ASC 740C Pitf ll T 10 Li tCommon Pitfalls – Top 10 List

1 Valuation allowances not considered for1. Valuation allowances not considered for each jurisdiction separately.

2. Tax law changes and tax law for each taxing jurisdiction not reflected in tax rate.

3. Recording uncertain tax positions with deferreds improperly or not computingdeferreds, improperly or not computing interest and/or penalties.

4. M&A transactions tax consequences not considered at Day 1 and during measurement period.

5 R ti t k ti i tl5. Reporting stock options incorrectly.

ASC 740C Pitf ll T 10 Li tCommon Pitfalls – Top 10 List

6. Proof of Deferreds - cumulative book/tax basis6. Proof of Deferreds cumulative book/tax basis differences not supported.

7. Accounting method changes – tax or book changes not consideredchanges not considered.

8. Interim provision not annualized properly.9. Reporting foreign investments -

representation to permanently re-invest foreignrepresentation to permanently re-invest foreign earnings or provide deferred tax; provide cumulative translation adjustment when company represents it will permanently reinvestcompany represents it will permanently reinvest.

10. Provision to return reconciliations – impact of true-up adjustments not properly reflected in financialsfinancials.

• Presentation of Financial Statements: • Financial Instruments with Characteristics of EquityCharacteristics of Equity

• Financial Statement Presentation

• Leases

Di ti d O ti R R iti• Discontinued Operations  • Revenue Recognition • Other Comprehensive Income • Consolidations

• Financial Instruments: • Fair Value Measurements• Accounting for Financial Instruments 

• FASB‐Only Projects

• Offsetting • Disclosure of Certain Loss• Offsetting • Disclosure of Certain Loss Contingencies

• Going Concern 

DisclosureDisclosure•To ensure compliance with Treasury Department regulations, p y p gany tax advice that may be contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-, , p p ( ) grelated penalties under the Internal Revenue Service Code or applicable state or local tax law provisions or (ii) promoting, marketing, or recommending to another party any tax-relatedmarketing, or recommending to another party any tax related matters addressed herein.

•Material discussed in this presentation is meant to provide general information and should not be acted on withoutgeneral information and should not be acted on without professional advice tailored to your firm’s or company’s individual needs.

Questions?Katherine D. Morris, CPA

Q

kmorris@smith-howard.com(404) 874 6244 office(404) 874-6244 office(404) 317-1883 cell