Letter of Comment No: q I File Reference: Date Received: g II~ 105

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1 Letter of Comment No: q I File Reference: Date Received: g II~ Paragon Drive Monlvale, NJ Tel: , Fax: t AI.,... of -\.-' ~ ~ ~f' if Certified Management Accountant Program Certified in Fin::mci31 Management Program September 8, 2005 Technical Director File Reference Financial Accounting Standards Board 40 I Merritt 7 P. O. Box 5116 Norwalk, CT I 16 Dear Sir: The Financial Reporting Committee (FRC) of the Institute of Management Accountants is writing to provide its views on the proposed Interpretation, Accounting for Un certain Tax Positions (the FIN or ED or proposed Interpretation). Given the diversity in practice that exists in thi s area, the FRC agrees with the need to provide additional guidance. However, our views on the proposal are more closcly aligned with the alternative view expressed by the dissenting memhers of the Board. That is, we believe that the gu idance proposed in the FIN, while reducing diversity in the application of FAS 109, Accountinx for Income Taxes, will not achieve a significant improvement in financial reporting. We believe that the recognition threshold proposed in the FIN will result in a recurring pattern of overaccruals of tax liabilities and subsequent recognition of even greater windfalls. If the Board moves forward with this approach, it will be important to educate investors that entities will no longer record some tax benefits that are reasonable of realization in the years in which they arise but will instead wait to recognize them in periods when the tax year is closed. As discussed further below, the FRC believes that such adverse effects are largely avoidable by changing the recognition threshold for determining when tax uncertainties should be recognized in financial statements. This letter provides our rccommended approach, supported by our basis, as well as views on other important aspects of the proposal. Detailed comments on the issues upon which comment is requested are provided in Appendix A.

2 September 8, 200S Financial Accounting Standards Board Page 2 Overview The FRe observes that this is a highly complex and difficult aspect of the accounting literature: the accounting for income taxes seeks to translate and present differences between two very different, highly technical regimes that are not always easily understood or explained. In addition, within this complex accounting framework, the proposal seeks to define a recognition principle for deductions on a tax return that until now FAS 109 failed to address explicitly. It is, therefore, understandable that knowledgeable individuals can arrive at well-reasoned views that differ significantly from one another--even on issues as fundamental as whether an asset or liability model is more appropriate. Such was the nature of the FRe discussions on the appropriate model for evaluating tax uncertainties. We have concluded that there is sufficient ambiguity within FAS 109's framework of principles that there is no single clear, obvious approach that flows directly from the guidance. In such cases, we believe that the Board's decisions should be guided by the decision-usefulness of the information that the FIN's principles will provide. Asset or Liability Approach? Some FRe members supported a liability approach under which recognition of tax benefits is governed by whether or not the underlying tax position had substantial authority under the tax law. Those members believe that, overall on a net cumulative basis, income taxes are liabilities and thus the model should be based on the principles of liability recognition and that the evaluation of tax uncertainties is a necessary part of measuring the taxes payable and deferred taxes properly. They note that tax professionals acknowledge that substantial authority (which some believe is as low as 30% probability) is the minimum level of support necessary to avoid penalties under the tax law. A tax position that meets that minimum standard is deemed valid under the tax law and should therefore be given accounting recognition, with appropriate measurement adjustments to fairly reflect the expected outcome of tax audits. The FRe members that subscribed to this approach would nevertheless assume that all such positions would be evaluated by the relevant taxing authority. In contrast, a majority of FRe members believe that the accounting for tax uncertainties is fundamentally an issue about when to recognize an asset. While this appears to be consistent with the conclusion in the ED, we do not agree with the Board's conclusion that it is a contingent asset. If the uncertain tax position is more likely than not of being sustained, we believe that the asset meets the eon 6 definition of an asset: that is, it is a probable future economic benefit obtained or controlled by the entity, which is defined as follows in fo otnote 18 of eon 6: Probable is used with its usual general meaning. rather than in a specific accounting or technical sense (sw.:h as that in FASB Statement No.5, AccouflIillg for Contingencies. par. 3), and refers to thai which can

3 September 8, 2005 Financial Accounting Standards Board Page 3 reasonably be expected or believed on the basis of avail able evidence or logic but is neither certain nor proved (Web ster's New World Dictionary oft"e American Language, 2d college cd. [New York Simon and Schustcr 19821, p. 1132). Its inclusion in the definition is intended to acknowl edge that business and other economic activities occur in an environment characteri zed by uncertainty in which few outcomes are certain (pars ). FRC members believe that when an uncertain tax position has met the highest confidence threshold required under the tax code (that is, more likely than not), it is no different than other assets recognized under CON 6 in the ordinary course of business. We believe that the Board has inappropriately analogized to FAS 5 for this aspect of tax uncertainties and that it has chosen to apply that standard 's principles selectively. For example, we note that the FIN's derecognilion provisions are inconsistent with FAS 5, which would have required derecognition when it is probable that the tax position will not be sustained. The FRC observes that the conclusion on the nature of the asset is critical to the issue of what the recognition threshold should be, which is discussed further below. Recognition Threshold The FRC believes that tax benefits claimed on a tax return should be recognized for accounting purposes if it is more likely than not that the underlying tax position will be sustained if challenged by a taxing authority. While our proposal differs from the altemative views expressed in the ED, we believe it shares many of the same benefits while also remaining true to many of the concepts underlying the ED principles. FRC members believe that a more likely than not threshold would result in a better picture of the true financi al position of an enterprise. We note that most tax disagreements are settled through negotiation rather than litigation. In practice, if a tax position is more likely than not of being sustained (in other words, the taxpayer has the better argument under tbe tax law), generally a significant portion of the impact of that position will be sustained in a negotiated settlement. It does not serve the users of fin ancial statements to fail to recognize any benefit for a tax position where the taxpayer has the bettcr position under tbe law (is more likely than not to win in litigation) and a significant portion of the benefit will be sustained in a negotiated settlement. Further, if the Board does not modify the proposal, we envision difficulty and diversity in practice in applying the proposed FIN 's probable threshold. We observe from past experience that it is problematic for the accounting literature to interlope into other disciplines by defining terms that are not recogni zed or used by the professionals who are required to work with them. For example, a "more likely than not" opinion from a tax expert does not necessarily imply that the position is not probable, as defined by the FIN. Tax professionals do not and will not provide legal opinions in accordance with the requirements of an accounting standard. They will render their opinions based on how they interpret thc tax law as applied to the specific facts and circumstan ces presented and characterize the strength of their view as they deem appropriate.

4 September 8, 2005 Financial Accounting Standards Board Page 4 We therefore believe that a more likely than not recognition threshold also will be more operational than a probable threshold and will result in less diversity in practice. Unit of Account The FRC believes that determining the appropriate unit of account for applying the FIN is an essential part of the proposed standard. The Board has failed to state a principle for unit of account, which leaves constituents in the position of divining a principle from the examples provided, with potential adverse consequences on the ability of constituents to apply the guidance as intended. In this regard, we find the research and experimentation credit example confusing. The FRC believes that the principle should be that the unit of account for a given tax position should be determined on a basis consistent with how those positions are analyzed and supported for purposes of review with the taxing authority. Given that the analysis of a tax position's merits for tax and accounting purposes are based on the same underlying data, the level at which this analysis is performed for tax purposes should be the appropriate starting point for accounting purposes. We note that an entity's past practice in documenting its tax positions is verifiable and objecti vely determinable and that this approach would substantially reduce the number of implementation issues that would otherwise ari se in this area. Measurement The FRC agrees with the Board 's conclusion to require use of the best estimate of the amount that will be sustained upon review by the taxing authority. However, we question the guidance in paragraph 12 that potentially overturns that conclusion because "the magnitude of the difference is sufficient to indicate that the probable thres hold has not been met." We believe that this guidance confuses recognition with measurement. We believe that if the tax position is based on the correct principles under the tax code, potential disagreements about the amoun t of the deduction should not overturn the conclusion that recognition of the benefit is appropriate. The FRC believes that this is the reason why a best estimate is used rather than the full amount of the deduction. Transition and Other Matters Our views on accounting for changes in judgment, di sclosure and transition are set forth in Appendix A. Importantly, with respect to transition, the FRC believes it is essential that companies be given more time to implement the final standard. ** ***

5 September 8, 2005 Financial Accounting Standards Board Page 5 We welcome the opportunity to di scuss these views further at your convenience. I can be reached at (513) Sincerely, Teri L. List Chair, Financial Reporting Committee Institute of Management Accountants

6 Appendix A Scope Issue i: This proposed Interpretation would broadly apply to all tax positions accounted f or in accordance with Statement 109, including tax positions that pertain to assets alld liabilities acquired in business combinations. It would apply to tax positions taken in tax returns previously filed as well as positions anticipated to be taken in future tax returns. Do you agree with the scope of the proposed Interpretation? Ifnot, why not? We agree with the scope of the proposed Interpretation. Initial Recognition Issue 2: The Board concluded that the recognition threshold should presume a taxing authority will, du ring an audit, evaluate a tax position taken or expected to be taken when assessing recognition of an uncertain tax position. (Ref er to paragraphs B12-B15 in the basis for conclusions.) Do you agree? /fnot, why not? We generally agree with the Board's conclusion that the initial recognition threshold should presume a taxing authority will evaluate a tax position taken or expected to be taken. However, we do wish to raise an issue in this regard. If the I ikelihood of examination of a position becomes "remote," should the effect of the position be recognized even if the statute of limitations has not expired? Examples of situations that may indicate there is only a remote likelihood of examination of the position include (I) where the relevant tax year or years have been audited and an aud it report has been iss ued without challenge to the position in question or (2) where the "normal" statute of limitations for a year has closed, there is an extended statute for certain circumstances but the likelihood of those circumstances applying is remote, or (3) where no return has been filed to begin the running of the statute of limitations, but subsequent returns for entities have been fil ed and accepted by the taxing authority without questioning the lack of returns for earli er years. We believe the Board should address these situations. In this regard, we do not believe the fact that a tax ing authority examines only a limited percentage of tax returns should be considered evi dence that the likelihood of evaluation of the position is remote. In addition, we believe the Board should reconsider its conclusion that each tax position must be evaluated for recognition without consideration of the possibility of offset or aggregation with other positions. Under the tax law, there is interaction between positions. The interaction may be mathematical--the loss of one position may change the dollar impact of another position, perh aps even eliminatin g any cost associated with loss of the second position. Al ternativel y, the interaction may be factu al. For example, tax position A and B may each fail to rise to a given level for recognition when viewed separately because of factual questions. However, if the facts are such that position A would be disallowed, those facts may cause position B to rise above the threshold for recognition. In other words, the taxpayer could lose position A or position B, but not both. This could involve a single

7 -2- tax jurisdiction, or cross-border situations with procedures (for example under a tax treaty) for resolving inconsistent tax positions. Ignoring the mathematical and factual interaction between positions could result in a liability that was more than the total amount at risk and therefore this prohibition should be reconsidered. Issue 3: The Board decided on a dual threshold approach thai would require one threshold for recognition and another threshold f or derecognition. The Board concluded that a tax position must meet a probable (as that term is used in Statement 5) threshold for a benefit to be recognized in the financial statements. (Ref er to paragraphs BI6-B21 in the basis f or conclusions.) Do you agree with the dual threshold approach? Do you agree with the selection of probable as the recognition threshold? If not, what alternative approach or threshold should the Board consider? We believe that a standard of "more likely than not" should apply to both the recognition and derecognition of the impact of a tax position. The ED states that the probable recognition threshold is a positi ve assertion that a tax position is valid under the tax law and the enterprise is entitled to the economic benefits associated with that position. A "more likely than not" threshold would also meet those criteria since, if that threshold is met, the tax payer has the correct position under the law and is entitled to the benefit of the position. Also, the Board has already ac knowledged, in connection with the derecognition threshold, that more likely than not is an acceptable standard for financial statement recognition when fair value is not available (paragraph B23). And a single recognitionlderecognition threshold will improve comparab ility of fin ancial statements across periods and between enterprises since similar tax positions would be treated in a similar manner if a single threshold were utilized. A more likely than not threshold would result in a better picture of the true financial position of an enterprise. Most tax disagreements are settl ed through negotiation rather than litigation. In practice, if a tax position is more likely than not correct (in other words, the taxpayer has the better argument under the tax law), generally a significant portion of the impact of that position will be sustained in a negotiated settlement. It does not serve the users of fin ancial statements to fail to recognize any benefit for a tax position where the taxpayer has the better position under the law (is more likely than not to win in litigation) and a significant porti on of the benefit will be sustained in a negoti ated settlement. In many situations where there is unsettled law, there may be a long history of settling a particular issue, for example at a 50% resolution. In such a situation, it may be difficult to reach a probable standard under the law and thus no benefit would be recogni zed under the proposed recognition threshold. In contrast, a more likely than not standard would allow recognition of a benefit (likely at a 50% or more level) in such a situation, whic h would present a more accurate picture to users of the fi nancial statements, without including any amount for positions where the enterprise doesn't have a valid claim to the benefit under the tax law.

8 - 3 - We also believe, in contrast to the conclusion of the Board in paragraph Bl7, that preparers, auditors and regulators would be more likely to agree on when a single more likely than not standard has been reached than they would on a dual recognition threshold. More likely than not is a standard that is provided for in US tax law (for example, Reg. Section (g». Tax practitioners regularly evaluate it in connection with settling or preparing to litigate issues, deciding which side has the better argument under the law and facts, and when a history of settlement negotiations with tax authorities could establish whether a tax position is more likely than not to be sustained. If the Board chooses to finalize the probable threshold for recognition, we believe that there should be at least two modifications to the list of examples that may, in the absence of opposing evidence, demonstrate a probable level of confidence. First, rather than "unambiguous tax law supporting the tax position," a more appropriate example would be "an analysis, prepared by personnel with sufficient subject matter expertise, of applicable law and facts, for which all conditions are objectively verifiable, which supports a conclusion that the probable threshold has been met for the tax position." As noted in the basis for conclusions (paragraph B21), there should not be a requirement to obtain an outside tax opinion. This should be the case even if there is some ambiguity in the tax law, provided that the preparer performs a complete analysis of the legal issues, similar to what woul d be presented in an outside opinion. Second, just as acceptance in a prior tax return should indicate a probable confidence level has been reached, a probable confidence level would be indicated if "the position has been obviously presented in the tax return and has either been accepted or not disallowed or challenged during the course of the examination." For many large corporate taxpayers, the examination and appeals process can extend over many years. There may be milestones during the process as indicated in the tax authority's work plan, work papers, oral communications or audit report that indicate that a position has been accepted. While the statute of limitations has not closed on the issue at that point, the completion of the audit of the position or area should indicate that the probable threshold has been reached. The FRC also believes that the Board needs to reconcile the guidance in paragraph 9(c) with the principle related to detection ri sk and provide additional guidance on how the final guidance would apply to tax issues that arise in the ordinary course of business. For example, with respect to the iss ue of whether a state tax jurisdiction can assert nexus, the entity may not be currently filin g a return in that state or it may have been filin g on a bas is that the tax ing jurisdiction does not have nexus. Subsequent Recognition Issue 4: The Board concluded that a tax position that did not previously meet the probable recognition threshold should be recognized in any later period in which the enterprise

9 -4- subsequently concludes that the probable recognition threshold has been met. paragraph B22 in the basis for conclusions.) Do you agree? if not, why not? (Refer to We agree with the Board that a position that has not been previously recognized should be recognized in the period where the threshold for recognition has been met. As previously discussed, we believe a better recognition threshold would be more likely than not. Derecognitioll Issue 5: Th e Board concluded that a previously recognized tax position that no longer meets the probable recogllition threshold should be de recognized by recording an income tax liability or reducing a deferred tax asset in the period in which the enterprise concludes that it is more likely than not that the position will not be sustained on audit. A valuation allowance as described in Statement 109 or a valuation account as described in FASB Concepts Statement No.6, Elements of Financial Statemellls, shmdd not be used as a substitute for derecognition of the benefit of a lax position. (Refer to paragraphs B23-B25 in the basis for conclusions.) Do you agree with the Board's conclusions OIL derecognition of previously recognized tax positions? ifnot, why not? We agree with the Board's conclusion on this issue. Measurement Issue 6: Th e Board concluded that once the probable recognition threshold is met, the best estimate of the amount that would be sustained on audit should be recognized. The Board concluded Ihat any subsequent changes in that recognized amount should be made using a best estimate methodology and recognized in the period of the change. (Refer to paragraphs 89-B11 and B in the basis for conclusions.) Do you agree with the Board's conclusions on measu rement? if not, why not? The FRC agrees with the Board's conclusion to require use of the best estimate of the amount that will be sustained upon review by the taxing authority. However, we question the guidance in paragraph 12 that potentially overturns that conclusion because "the magnitude of the di fference is sufficient to indicate that the probable threshold has not been met." We believe that this guidance confuses recognition with measurement. We believe that if the tax position is based on the correct principles under the tax code, potential disagreements about the amount of the deduction should not ovelturn that conclusion. (In this regard, we suggest that the las t sentence in paragraph B29 be included in paragraph 12.) The FRC believes that this is the reason why a best estimate is used rather than the full amount of the deduction, that is, the extent of the difference is not the key. Classification Issue 7: The Board concluded that the liability arising from the difference between the tax position and the amount recognized and measured pursuant to this proposed interpretation should be classified as a current liability for amollnts that are anticipated to be paid within one

10 - 5 - year or the operating cycle, if longer. Unless that liability arises from a taxable temporary difference as defined in Statement 109, it should not be classified as a deferred tax liability. (Refer to paragraphs B30-B35 in the basis for conclusions.) Do you agree with the Board's conclusions on classification? If not, why not? We agree with the Board's conclusion on classification. We believe it is consistent with ARB 43. Change in Judgment Issue 8: The Board concluded that, consistent with the guidance in paragraph 194 of Statement 109, a change in the recognition, derecognition, or measurement of a tax position should be recognized entirely in the interim period in which the change in judgment occurs. (Refer to paragraph B36 in the basis for conclusions.) Do you agree with the Board's conclusions about a change in judgment? If not, why not? We acknowledge a diversity of views on this issue and believe guidance would be useful. A majority of FRC members support a view that would be driven by whether the change in judgment relates to prior year items or current year items. Changes related to prior year items would be handled discretely in the interim period, whilc changes related to current year items would be factored into the effective rate. This view seems most consistent with FIN 18. An alternative view that found support with some members of the FRC follows. For many large taxpayers, because of the continuous nature of federal, foreign and state audit processes, there are changes in every period to the tax liability that would be recorded for prior periods. Many of these changes are much less significant, and much less unusual, than planning transactions that would be reflected in the annual effective tax rate calculation. Users of financial statements would not benefit from having changes in judgment that relate to nonnal, routine examination activity segregated from the rest of the effective tax rate calculation and, in fact, we understand that users frequently "normalize" effective tax rates in their analyses. This is in contrast to tax law changes, which arc much less frequent, and typically much more significant, in terms of impact on the effective tax rate. Consistent with the overall guidance in APB 28, changes in recognition, derecognition or measurement should be recognized entirely in the interim period in which they oceur if they arc unusual. Both the frequency of such adjustments for the preparer and the size of the adjustment would be considered in determining whether the change in judgment was unusual for a particular enterprise. Interest and Penalties Issue 9: The Board concluded that if the relevant tax law requires payment of interest on underpayment of income taxes, accrual of interest should be based on the difference between the tax benefit recognized in the financial statements and the tax position in the period the interest is

11 -6- deemed to have been incurred. Similarly, if a statutory penalty would apply to a particular tax position, a liability for that penalty should be recognized in the period the penalty is deemed to have been incurred. Because classification of interest and penalties in the income statement was not considered when Statement 109 was issued, the Board concluded it would not consider that issue in this proposed Interpretation. (Refer to paragraphs B37-B39 in the basis for conclusions.) Do you agree with the Board's conclusions about recognition, measurement, and classification of interest and penalties? If not, why nor? If the FASB accepts our recommendation on Issue 3, we agree with the Board's conclusion about recognition, measurement and classification of interest and penalties. Otherwise, we di sagree. Combining the Board's conclusions on Issue 3 and Issue 9 results in amounts being accrued that will likely never be paid. Disc/osClres Issue 10: Th e Board concluded that loss contingencies relating to previously recognized tax positions should be disclosed in accordance with the provisions of paragraphs 9-11 of Statement 5. The Board also concluded that liabilities recognized in the financial statements pursuant to this proposed Interpretation f or tax positions that do not meet the probable recognition threshold are similar to contingent gains. Th erefore, those liabilities should be disclosed in accordance with the provisions of paragraph 17 of Statement 5. (Refer to paragraph B40 in the basis for conclusiolls.) Do you agree with the disclosure requirements? if not, why not? We agree with the Board's conclusions on disclosure. Some members of the FRC would like the FASB to provide realistic examples to illustrate the disclosure requirements and better communicate the Board's expectations. They believe this would aid practitioners and result in more consistent practice. However, the majority of FRC members would prefer to use their own judgment ill this regard. Examples can become the rules that must be rigidly followed in all cases. Effective Date and Transitioll Issue 11: Th e Board concluded that this proposed Interpretatioll should be effective as of the end of the first fiscal year ending after December 15, Only tax positions that meet the probable recognition threshold at that date may be recogllized. Th e cumulative effect of initially applyillg this proposed Illtelpretation would be recognized as a change in accounting principle as of the end of the period ill which this proposed Interpretation is adopted. Restatement of previously issued interim or annual financial statements alld pro forma disclosures for prior periods is not permitted. Earlier application is en couraged. (Refer to paragraphs B4I- B43 in the basis for conclusiolls,) Do you agree wilh the Board's collclusions 011 effective date? if 1I0t, how much time would YO It anticipate will be necessary to apply th e provisions of this proposed Interpretation? Do you agree with the Board's conclusions Oil transition? if not, why not?

12 - 7 - We do not agree with the Board's conclusion on effective date. Given the potential for significant interpretation questions, the likelihood of a final standard being issued late in the year, and the time needed to gather the information necessary to make the judgments, we believe that it would benefit both preparer and users of financi al statements if the effective date were delayed. We suggest an effective date of fiscal years beginning after July 15,2006. We prefer a beginning-of-year adoption-mid-year adoption is problematic. We would permit early adoption with restatement of prior quarters. We also note in this regard the implication of Section 404 of the Sarbanes-Oxley Act. The ED requires judgments different from those many entities have made in the past, for a potentially large population of uncertain tax positions. For a quality implementation, companies need time not just to analyze the uncertain tax positions in all taxing jurisdictions for all open tax years, they also need to develop and implement new internal controls that are supportive of the fin al standard. Further, we believe that the impact at the effective date should be computed applying the derecognition threshold rather th an the recognition threshold. As acknowledged by the Board (paragraph 2), there is significant diversity of practice currently. Some preparers may have been largely following the concepts of the ED. If the concepts of the ED were followed, there should be no impact to the adoption of the proposed Interpretation. However, since the impact of positions would normally be derecognizcd under the proposed Interpretation only if a more likely th an not threshold were not maintained, but would be derecognized at adoption if less than probable, there would be an adoption impact even for those preparers already following the methodology of the proposed Interpretation. The threshold for derccognition upon adoption should be the same as the normal threshold for derecognition, more likely than not. (We also note that this issue would be less problematic if our recommendation in Issue 3 were accepted.) Other Commellts We have the following other comments: 1. Assuming the FASB proceeds to a final standard, it will need to amend paragraph 39 of FAS 5 to eliminate the income tax example because FAS 5 may no longer be used to assess tax uncertainties. 2. We understand that some practitioners have seen a relationship between the proposed Interpretation and accounting for defened taxes related to stock options under FAS 109 where a deep out-of-the-money option is required to be accounted for as if a deduction for the full grant date fair value will be received, even though the best estimate of the actual deduction may be zero. We see no such relationship. The FASB has set forth guidance on the stock option issue in FAS 123R and that matter involves no uncertainty as to the amount or existence of the temporary difference or as to the application of the tax law. Perhaps there is an uncertainty

13 - 8 - but not the type addressed in the proposed Interpretation. But because some see a relationship, we recommend the Board set forth its views with respect to the ED as well as the deferred tax asset recognition standard in FAS 109 generally.