Uncertain tax positions and FIN 48: practical recommendations

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1 OCTOBER 31, 2006 Uncertain tax positions and FIN 48: practical recommendations The time for adoption of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48) is fast approaching the first fiscal year beginning after December 15, Public companies and other companies that issue certified financial statements under U.S. GAAP rules with a calendar year fiscal year should have scrubbed their tax reserves by January 1, 2007, in order to avoid the need to make potentially awkward disclosures next year. Accordingly, tax departments need to determine what steps to take now. This Tax Alert provides some practical recommendations on steps to take in the next few months but is not intended to be a technical summary of FIN 48 s rules. This Tax Alert also summarizes the IRS release on October 17, 2006 relating to procedures to expedite resolution of issues in light of FIN 48. What is the problem? FIN 48 increases the likelihood that for financial reporting purposes (i) the deferred tax asset account must be reduced by the amount of tax benefits claimed yet not expected to be realized, and (ii) unrecognized tax benefits will have to be recognized as liabilities. This is because FIN 48 focuses primarily on technical tax law, rather than the common prior practice of reliance on general experience and settlement expectations. In addition, FIN 48 increases the likelihood that adjustments to tax reserves will have to be made periodically (e.g. quarterly). The tax reserve and effective tax rate will be more volatile. Once it is determined that all or a portion of a material tax benefit that was claimed on an income tax return is not likely to be sustained, then the expense must either be booked or failure to book it must be disclosed in the company s financial reports. This could provide a roadmap for IRS examination agents and other tax authorities. A key question is the extent to which financial auditors will require disclosures of individual positions and jurisdictions, as opposed to aggregating positions and jurisdictions. For example, if a company sells a line of business that operates in forty states, will it have to discuss the business and non-business income tax treatment for each of the forty states? We understand that some accounting firms currently believe that FIN 48 does not require individual jurisdictions to be identified in disclosures, and will permit jurisdictions and even 1 of 6

2 tax positions to be aggregated. However we understand that in discussing reasonably possible significant changes in recognized tax benefits over the next twelve months, more specificity will be required, including possibly naming individual jurisdictions. Identifying uncertain tax positions The tax department s first step is to identify all material income tax exposures existing as of the adoption date. This can be a challenging task for companies that operate in multiple states and localities and countries other than the U.S. The tax department should organize its material tax positions by jurisdiction and by year. Material tax positions should be identified in each year that remains open to assessment and collection by the relevant tax authorities as of the initial adoption date. Some of the most vexing issues arise where the company has not filed income tax returns in a state or locality, but may have nexus. In most jurisdictions, if a return is never filed, the statute of limitations for assessment never runs. However, FIN 48 permits companies to rely to some extent on widely held administrative practices. If a company can establish that a jurisdiction s administrative practice with respect to a non-filer is not to assess income taxes in excess of six years, then the company may be able to limit its exposure to six years. FIN 48 applies only to income taxes. It is not clear if some taxes are income taxes for FIN 48 purposes, such as the new Texas margin tax or various local gross receipts-based taxes. Evaluating uncertain tax positions A tax benefit can only be realized where there is a greater than 50 percent likelihood of the position being upheld. When making this assessment, the tax department must assume that (i) the tax authority will examine the tax position (the possibility that the company will not be audited or that the issue will be missed in an audit cannot be taken into account); (ii) the examiner will have full knowledge of all relevant information; (iii) each tax position will be examined separately with no consideration of offset for other positions; and (iv) the conclusion must assume that the position is resolved in the court of last resort (e.g., U.S. Supreme Court or state supreme court). Sources of authority for tax positions derive from the usual sources statutes, regulations, rulings, court cases, etc. An important source mentioned in FIN 48 is widely-held administrative practice. Eliminating uncertainty -- state and local tax voluntary compliance initiatives If a tax position is not likely to be sustained, and it involves a state and local tax issue, we are seeing some companies participate in state and local voluntary compliance initiatives. Consider a company that has nexus in a state but has failed to file state income tax returns. The failure to file position could have to be disclosed after the adoption date of FIN 48. Because the statute of limitations never expires on an unfilled income tax return, the company may have to maintain an indefinite accrual. As an alternative, prior to the adoption date, the tax departments of some companies are engaging representatives to make anonymous inquiries regarding the state s willingness to resolve the matter on a compromise basis, in terms of taxes, interest, and penalties, and limiting the tax years for which payments would be made. If the state is willing to compromise, then these companies are coming 2 of 6

3 forward and agreeing on a closing agreement and making the agreed-upon payments, with the result that the resolved uncertain tax positions do not have to be disclosed. Some companies that are currently being audited are attempting to expedite the resolution of matters and to reach a reasonable settlement before the adoption date of FIN 48. Eliminating uncertainty new IRS initiative On October 17, 2006, the IRS s Large and Mid-Size Business Division issued a release informing taxpayers of a new initiative intended to help taxpayers greatly accelerate the resolution of uncertain tax positions prior to FIN 48 s adoption date. Under this initiative, the IRS will work with a taxpayer to resolve an uncertain tax position, if the taxpayer submits a request to the IRS at least 45 days before its financial statement year end date, under the following three circumstances: Return containing position filed and taxpayer under examination. The taxpayer submits its request to accelerate resolution of its uncertain tax positions to its IRS examination team, even if the particular tax return containing the position is not the return under examination. The parties may use any currently available dispute resolution tool (e.g., Fast Track Appeals (Rev. Proc ), Early Referral to Appeals (Rev. Proc ), and Accelerated Issue Resolution (Rev. Proc )) to resolve the issue on an expedited basis. Return containing position filed but taxpayer not under examination. The taxpayer submits its request to accelerate resolution of its position to an IRS contact listed in the release. The parties may use any currently available dispute resolution tool to resolve the issue on an expedited basis. Return to contain the position not yet filed. The taxpayer follows the procedures in Rev. Rul (concerning pre-filing agreements), and submits its request to accelerate resolution of the issue. IRS and the taxpayer may use the pre-filing agreement process to resolve the issue. An issue may be resolved under this initiative only if it is otherwise appropriate for a pre-filing agreement. Under Rev. Rul , the IRS will only consider issues that require either a determination of facts or the application of well-established legal principles to known facts. This new IRS initiative does not actually introduce any new dispute resolution methods. It does require IRS personnel to attempt to follow procedures to speed up the resolution of the issue. IRS personnel are required to attempt to respond to a request within one business day of receiving it. If the IRS accepts the request, IRS personnel and the taxpayer are to establish expectations regarding a closure date and agree on a timeline to meet specific objectives. The IRS will agree to employ its best efforts to resolve the matter within the agreed timeline and to have in attendance at meetings those individuals necessary to resolve any problems, issues, and/or concerns. Participating taxpayers must submit the following information: a description of the issue, a summary of all relevant facts, any transactional documents, a document containing all relevant authorities, original documents relating to the taxpayer s risk assessment of the issue, and a description of where the uncertain tax position appears or will appear on the taxpayer s return. The taxpayer and/or its representative must then meet with the IRS and 3 of 6

4 fully explain all relevant facts and present all arguments for and against its uncertain tax position. If the taxpayer and IRS resolve the issue, the parties will sign a Form 906 closing agreement reflecting the resolution. At any time prior to the execution of the closing agreement, either the taxpayer or the IRS may withdraw from consideration all or part of the request. The IRS will not agree to resolve certain issues under its initiative, such as any issue that has been designated for litigation or that is being litigated by the taxpayer in a current court proceeding. Taxpayers who otherwise desired to have their issues resolved at the Appeals level may want to take advantage of the expedited process. Not all matters may be ripe for expedited resolution, particularly if all the relevant facts have not yet been developed. In addition, the IRS s insistence that participating taxpayers disclose all original documents relating to the taxpayer s risk assessment of the issue will inhibit some taxpayers from participating in this initiative. Documentation and tax opinions - outside assistance Tax departments need to consult with their financial auditors now in order to determine what documentation will be required, and whether tax opinions will be required, to support a more-likely-than-not tax position. Meeting with auditors up front could avoid an unpleasant surprise near the date of FIN 48 s adoption. In practice, auditors may be undecided about exactly what they will need, in part because this is a new area for them as well as for taxpayers. They may also believe that it is not their role to provide taxpayers with such guidance. Accordingly, tax departments may want to prepare for a worst-case scenario a last minute demand for additional documentation. A recent survey of companies that are part of the Corporate Executive Board indicates that tax departments are taking the following steps to support their uncertain tax positions: preparation of in-house tax memoranda (78 percent) preparation of in-house counsel tax opinions (35 percent), and reliance on outside counsel opinions (54 percent). The survey also indicates that most tax departments have not received adequate guidance from their financial auditors to determine the level of documentation that the auditors will require under FIN 48. In general, with respect to uncertain tax positions, a tax department should be willing to seek outside assistance if it does not have the requisite resources or expertise. For example, tax departments need to understand if they are knowledgeable about administrative practices with respect to a tax position, and if they are not, be willing to seek outside assistance. If a company refuses to book an expense related to an uncertain tax position, the financial auditors may insist on the preparation of a tax opinion by an independent firm, in the belief that an outside opinion provides increased protection for the financial auditors. Even if one is not insisted upon, such a tax opinion (or memorandum) prepared by an outside firm may more likely be viewed as persuasive by the financial auditors, as it will be coming from an independent tax advisor. A commonly underestimated aspect of supporting an uncertain tax position is the need for documentation and background facts. Often, the facts determine the outcome of a legal 4 of 6

5 matter. But frequently the facts are not easily at hand and time and effort is needed to develop them. It may be helpful to retain legal counsel for this task, as they are trained to develop facts and gather documentation, and they provide a broad attorney-client privilege protection. One area that is particularly difficult to deal with is the interaction of non-u.s. income taxes and U.S. federal tax credit utilization. The tax systems of foreign jurisdictions often are not as developed as those in the U.S. and therefore there is often uncertainty in the foreign tax treatment. Still, a tax department must assess the uncertainty and conclude how it will affect the company s utilization of its foreign tax credit. The tax department must also have adequate procedures for accurately calculating interest and penalties. Thoughts on the post-adoption world FIN 48 promises to have a significant impact on tax positions that companies take on future income tax returns. In general, we expect that companies will be more conservative and will be more hesitant to engage in tax-motivated transactions. We also expect that companies will be more likely not to claim an uncertain tax position on a tax return and instead to rely more on the tax refund route. In addition, we anticipate that more taxpayers will engage in internal restructurings to eliminate state tax motivated structures, such as Delaware and Nevada holding company structures. If you would like more information regarding the assistance that Nixon Peabody can provide in connection with this matter, please call Christian McBurney at (202) , him at cmcburney@nixonpeabody.com, or contact your regular Nixon Peabody liaison. IRS Circular 230 Disclosure: To ensure compliance with IRS requirements, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. The foregoing summary is provided by Nixon Peabody LLP for educational and informational purposes only. It is not a full analysis of the matter summarized and is not intended and should not be construed as legal advice. This publication may be considered advertising under applicable laws. 5 of 6

6 Tax Team Please feel free to call or your usual contact or any of the partners or associates in our Tax Team listed below. ATTORNEY NAME PHONE Stefan R. Boshkov sboshkov (212) Scott F. Cristman scristman (585) Thomas M. Farace tfarace (585) Mark M. Foster mfoster (415) Christian M.McBurney cmcburney (202) Kenneth H. Silverberg ksilverberg (202) Scott M. Susko ssusko (617) Robert A. Thompson rthompson (617) Boston, MA 100 Summer Street Los Angeles, CA 555 West Fifth Street, FL New York, NY 437 Madison Avenue Rochester, NY 1100 Clinton Square San Francisco, CA Two Embarcadero Center Washington, DC 401 Ninth Street NW, Suite Albany, NY 30 South Pearl Street Buffalo, NY 40 Fountain Plaza, Suite Hartford, CT 185 Asylum Street Long Island, NY 50 Jericho Quadrangle, Suite Manchester, NH 900 Elm Street McLean, VA 2010 Corporate Ridge, Suite Palm Beach Gardens, FL 4400 PGA Boulevard, Suite Philadelphia, PA 1818 Market Street, FL Providence, RI One Citizens Plaza of 6