Question

If a company excluded the tax refund from taxable income, and did not record an unrecognized tax benefit, what must the company believe about whether the IRS and tax courts will challenge and allow this exclusion? Explain using the language of FIN 48.

Answer 1

FIN 48 (mostly codified at ASC 740-10) is an official interpretation of United States accounting rules that requires businesses to analyze and disclose income tax risks. It was effective in 2007 for publicly traded entities, and is now effective for all entities adhering to US GAAP. A business may recognize an income tax benefit only if it is more likely than not that the benefit will be sustained. The amount of benefit recognized is based on relative probable outcomes.

FIN 48 Compliance: Disclosing Tax Positions in an Age of Uncertainty

In short

1. The interaction of FAS 109 and FIN 48 will result in greater public disclosure of tax planning techniques.

2. Under FIN 48, a tax position is recorded only if the tax position is more likely than not to be sustained on examination (including related appeals or litigation processes).

3. A material tax position is tested under a two-step process consisting of a recognition step and a measurement step.

4. FIN 48 requires a reevaluation of all tax positions at the end of each reporting period. Prior recognized positions may be derecognized or remeasured, and prior unrecognized positions may be recognized in each reevaluation.

FIN 48 is a response to the perceived public desire for greater transparency of financial data and is in part a result of the abusive tax-shelter activities of the 1990s and the financial accounting scandals of the early 2000s. Questions arose regarding potential manipulation of reported earnings, including managing the effective tax rate reported in financial statements. Furthermore, a large number of the material weaknesses and significant deficiencies initially reported under Sarbanes-Oxley were traceable to the construct of the entity’s income tax expense. In the tax realm, regulatory responses to the perceived desire for greater financial transparency led to new Schedule M-3 reporting requirements for corporations and passthrough entities, which require book-tax differences to be disclosed in two columns, one for temporary differences and one for permanent differences. Items disclosed in the temporary column should agree with items used to compute deferred tax assets and liabilities under FAS 109, while permanent differences should agree with items used to compute the effective tax rate.

In addition to accruing the tax, FIN 48 requires disclosures in footnotes to the financial statements. Year end statements must include:

1. A tabular reconciliation of unrecognized tax benefits,
2. The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate,
3. Total interest and penalties recognized in the analysis,
4. Unrecognized tax benefits that may significantly change within 12 months of the financial statements, and
5. A description of tax years that remain subject to examination, by major applicable tax jurisdiction.