RSM Resources

The Financial AccountingStandards Board (FASB) recently issued an interpretation that may leaveexecutives at midsized companies scrambling to comply. FASB Interpretation No.48 (FIN 48) requires companies to rigorously assess the merits of uncertaintax positions taken on any tax return for any "open" tax year.Generally, tax returns are considered open to audit by taxing authorities forthree years following the filing date.

What is an uncertain taxposition?

All companies seek tolegitimately reduce their overall tax burden and minimize or delay cashoutflows for taxes. Positions taken in tax returns may be well-grounded and ingood faith, but with the complexities and varying interpretations of the taxlaw, these positions may not ultimately prevail. Complexity creates uncertaintyregarding the actual benefit a company will receive from a position taken onits tax return. FIN 48 establishes a uniform process for determining whetherthe tax benefit resulting from a position taken on a tax return should berecognized in the financial statements of an entity.

Common examples of uncertaintax positions include characterizing gains or losses as capital gains orlosses, claiming a tax credit, allocating income between jurisdictions (or notfiling a return when a company believes it does not have nexus in a state orcountry), excluding income the company believes is tax-exempt, and taking a taxdeduction.

Compliance deadline is fastapproaching (or may already be here)

For midsized companieswithout a large in-house tax department or the ability to dedicate multiplestaff members to a special project, complying with this interpretation couldprove daunting, especially for those that file in multiple states andcountries.

FIN 48’s aggressive timelinemagnifies the problem. For calendar-year-end companies, FIN 48 is effective for2007. Calendar-year companies that only issue year-end annual financialstatements are not required to adopt FIN 48 until they issue their financialstatements at the end of 2007.

Companies that issue GAAPfinancial statements monthly or quarterly— as required by their bank or bySecurities and Exchange Commission (SEC) rules — must comply with FIN 48 fortheir interim statements, as well. For these companies, the compliance deadlineis fast approaching (or may already be here).

The FIN 48 approach

FIN 48 utilizes a two-stepapproach for evaluating tax positions. It addresses the recognition andmeasurement of income tax positions using a "more-likely-than-not"threshold. More likely than not (MLTN) is defined as more than 50 percentprobability.

Step one: recognition. UnderFIN 48, the FASB may not recognize a benefit related to an uncertain taxposition in the financial statements unless it is MLTN (more than 50 percentprobable) the position will be sustained based solely on its technical merits.

Step two: measurement. Thetax benefit of a qualifying position is measured as the greatest possible taxbenefit that is more than 50 percent likely to be realized upon ultimatesettlement with a taxing authority. This poses significant challenges inevaluating tax positions in various state, local and foreign jurisdictions.

Consider the example of"Company A." Company A takes a $100 research and development crediton its federal income tax return and reduces its taxes paid for the year by$100. Management believes its R&D expenditures meet all the criteria toqualify for the entire credit.

Based on past history ofsimilar tax credits, however, the company’s tax officials believe there’s just 40percent likelihood that, if the company was audited, the IRS would allow theentire credit. But they believe there is at least 51 percent likelihood the IRSwould allow $80 of that credit. FIN 48 would allow the company to recognizethat $80 tax benefit in its financial statements. The remaining $20 wouldappear as a liability in the company’s financial statements.

Prior to FIN 48, Company Aofficials might have arrived at their $80 prediction (or some other amount)using various thresholds of probability they deemed appropriate. Likewise, theymight have reported the $20 liability in various ways within the company’sfinancial statements. FIN 48 establishes a uniform approach.

FIN 48 does not requirecompanies to restate previously issued financial statements for liabilityadjustments required because of its adoption. Instead, the cumulative effect ofthe change may be presented as an adjustment to the company’s beginning retainedearnings in the year of adoption.

Choosing a partner

While some midsizedcompanies will have the time and internal resources to comply with FIN 48,others will need to seek outside assistance. Publicly traded companies needingoutside help must be aware of SEC independence rules limiting the assistancethe company’s independent auditors can provide.

If you choose to select anexternal partner to help you meet FIN 48 requirements, experts offer thefollowing tips.

• Start your search as earlyas possible. Many other companies will be seeking similar help to meet the sametight deadlines.
• Ensure your partner iswell-versed in GAAP as well as in the tax laws and tax case history of eachstate and country where your company does business.
• Select a partner who canfacilitate communication between your auditors, tax professionals and otherexternal parties. As with any new ruling, it will likely take some time todetermine all the documentation requirements and ensure best practices. Themore all the players communicate upfront, the less likelihood there is ofunpleasant surprises down the line.

FIN 48 is applicable to allentities whether they are privately owned, publicly traded or not-for-profitorganizations. Can your organization comply with this far-reachinginterpretation?