FIN 48 Accounting for Uncertainty in Income Taxes and Other FAS 109 Topics

1
FIN 48Accounting for Uncertainty in Income
Taxesand Other FAS 109 Topics
2
Introductions Agenda
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Introductions

• Glen Kohl, Sr. VP, Tax and TreasuryElectronic
  Arts
• Jeff Sokol, PartnerDeloitte
• Rob Terpening, PartnerBDO Seidman LLP
• Rusty Thomas, PartnerKPMG
• Neil Traubenberg, Vice President, TaxSun
  Microsystems

4
Todays Agenda

• FIN 48 Overview
• FIN 48 Difficult Issues
• FAS 109 Common Errors

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Overview - Reason for Interpretation

• Diverse accounting practices in applying
  Statement 109
• Lack of comparability
• Evolution of the Standard
• Comment Letters

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Scope What is a Tax Position?

• Tax benefit on return filed or expected to be
  filed
• Reduce income tax expense, taxes paid or payable
• Increase tax benefit and receivable, DTA or
  refund
• Decision not to file a return
• Allocation or shift of income between
  jurisdictions
• A characterization of income
• A decision to exclude income, or treatment of a
  transaction, entity or other position as tax
  exempt

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Step 1 Initial Recognition of Tax Benefits

• Determine unit of account
• Facts and circumstances in light of all available
  evidence
• Consider
• Manner in which company prepares and supports tax
  return
• Approach the company anticipates the taxing
  authority will take during an examination

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Step 1 Initial Recognition of Tax Benefits

• In order to recognize any amount of benefit, for
  the unit of account, the position must be MLTN of
  being sustained based solely on the technical
  merits
• The position will be examined
• The examiner will have full knowledge of all
  relevant information
• Evaluation based solely on the technical merits
• No offset or aggregation of positions
• Conclusion should assume resolution in the court
  of last resort

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Step 1 Initial Recognition of Tax Benefits

• Highly certain tax positions
• Clear and unambiguous tax law
• Consistent with will prevail opinion
• Extent of evidence and documentation requires
  judgment
• Administrative practices and precedent
• Applies where there has been a technical
  violation of law
• Expected to be relevant infrequently
• Evidence and documentation

10
Step 2 - Measurement

• For a tax position that meets the
  more-likely-than-not recognition threshold
• Measure initially and subsequently as the largest
  amount of tax benefit that is greater than 50
  likely of being realized upon ultimate settlement
  with a taxing authority having full knowledge of
  all relevant information
• Consider the amounts and probabilities of the
  outcomes that could be realized upon ultimate
  settlement
• Based on facts, circumstances, and information
  available at the reporting date

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Illustrative Guidance Measurement with
Information about Approach to Settlement

• Scenario
• The enterprise has determined that a tax position
  resulting in a benefit of 100 qualifies for
  recognition and accordingly should be measured
• The enterprise has considered the amounts and
  probabilities of the estimated outcomes.

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Illustrative Guidance Measurement with
Information about Approach to Settlement

• Table of Probabilities Estimated Outcomes

Possible Estimated Outcome Individual Probability of Occurring Cumulative Probability of Occurring
100 5 5
80 25 30
60 25 55
50 20 75
40 10 85
20 10 95
0 5 100
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Illustrative Guidance Measurement with
Information about Approach to Settlement

• 60 is the largest amount of benefit that is
  greater than 50 likely of being realized upon
  settlement
• Actually its 60 or more that is greater than
  50 likely of being realized upon settlement
• Probability of 60 itself is only 25
• The At least Test Book the largest number as
  to which it is more likely than not that the
  taxpayer will realize at least that number.

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Illustrative Guidance Measurement with
Information about Approach to Settlement

• Table of Probabilities Estimated Outcomes

Possible Estimated Outcome Individual Probability of Occurring Cumulative Probability of Occurring
100 25 25
50 50 75
0 25 100
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Illustrative Guidance Measurement with
Information about Approach to Settlement

• Table of Probabilities Estimated Outcomes

Possible Estimated Outcome Individual Probability of Occurring Cumulative Probability of Occurring
100 10 10
65 80 90
0 10 100
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Tax Planning Strategies and Valuation Allowance

• Tax planning strategies
• Consideration required under FAS 109
• Discussed in paragraphs 20-22 of FAS 109 in
  conjunction with future realizability of DTA, and
  corresponding need for (and size of) valuation
  allowance
• If contemplated as source of future taxable
  income to support realizability of DTA, must meet
  recognition and measurement criteria of FIN 48

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Subsequent Recognition, Derecognition,
Measurement

• Subsequent Recognition
• A tax position which previously did not meet the
  recognition threshold gets recognized in the
  first interim period in which
• The more-likely-than-not recognition threshold is
  met by the reporting date, or
• The tax matter is settled through negotiation or
  litigation, or
• The statute of limitations for the tax position
  has expired
• A tax matter need not be legally extinguished to
  subsequently recognize or measure a tax position
• Based on managements best judgment in view of
  facts, circumstances, and information available
  at reporting date

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Subsequent Recognition, Derecognition,
Measurement (continued)

• Derecognition
• Derecognize (previously recognized) tax position
  in the first interim reporting period in which it
  is no longer more likely than not that the
  position will be sustained upon examination
• Valuation allowance is not a substitute for
  derecognition
• Based on managements best judgment in view of
  facts, circumstances, and information available
  at reporting date

19
Changes in Judgment

• Changes in judgment resulting in subsequent
  recognition, derecognition, or change in
  measurement of tax position taken previously
• If initial tax position was taken in prior annual
  period, recognize change as discrete item in
  period of change
• If initial tax position was taken in prior
  interim period within same fiscal year, apply APB
  28 (Interim Financial Reporting) and FIN 18
  (Accounting for Income Taxes in Interim Periods)
  to take change into account over remaining
  periods in fiscal year using effective tax rate
  calculated for interim period
• Based on evaluation of new information not new
  evaluation, or new interpretation by management,
  of information that was available in previous
  period
• Analysis must be conducted every reported period

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Interest and Penalties

• Interest
• FIN 48 requires accrual if position in tax return
  is not recognized in financial statements under
  FIN 48
• When tax law requires interest on underpayment,
  start recognizing in 1st period it would begin
  accruing under tax law
• Amount is statutory interest rate times
  difference between FIN 48 tax position and amount
  taken in tax return
• Penalties
• Recognize when tax position does not meet minimum
  statutory threshold to avoid payment of penalties
• Recognize in period in which company claims or
  expects to claim position in tax return

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Classification

• Unrecognized tax benefit concept
• Difference between position in tax return and
  benefit recognized and measured under FIN 48
• Creates liability (or reduces amount refundable
  or DTA, e.g., NOL)
• Represents companys potential future obligation
  to taxing authority for tax position taken in tax
  return but not recognized pursuant to FIN 48
  recognition/measurement guidance
• Again, not actually limited to positions in
  return but to any tax position
• Liability is current or non-current based on
  expected timing of payment of cash
• Current if within one year (or operating cycle,
  if longer)
• Liability recognized is generally not a deferred
  tax liability
• DTL only if it arises from a taxable temporary
  difference
• Interest recognized under FIN 48
• Accounting policy decision to classify as either
  income taxes or interest expense

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Disclosures

• Accounting policy for classification of interest
  and penalties
• At the end of each annual reporting period
• Tabular rollforward of unrecognized tax
  benefits (UTBs) at beginning and end of period
• Total amount of UTBs that, if recognized, would
  affect the effective tax rate
• Total amount of interest and penalties recognized
  in the income statement and balance sheet
• Description of tax years that remain subject to
  examination by major jurisdictions
• Paragraph 21(d) - Positions where it is
  reasonably possible that the total amounts of
  UTBs will significantly increase or decrease
  within 1 year of reporting date
• Nature of uncertainty
• Nature of event that would cause the change
• Estimate of range of change, or statement that
  cant estimate

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Disclosures

• Tabular rollforward includes
• Gross amts of increases decreases in UTBs as a
  result of tax positions taken during a prior
  period
• Gross amts of increases decreases in UTBs as a
  result of tax positions taken during the current
  period
• Decreases in UTBs relating to settlements with
  taxing authorities
• Decreases in UTBs resulting from lapses in
  statutes of limitations

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Illustrative Guidance - Tabular Rollforward
(in millions)
Balance at January 1, 2007 370,000
Additions based on tax positions related to the current year 10,000
Additions for tax positions of prior years 30,000
Reductions for tax positions of prior years (60,000)
Settlements (40,000)
Balance at December 31, 2007 310,000
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Disclosures

• Rollforward/reconciliation roadmap?
• FIN 48 tabular rollforward requires disclosures
  only at aggregate level, not at individual tax
  position level
• Not by jurisdiction
• Not tax position by tax position

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Disclosures

• Paragraph 21(d)
• Positions where it is reasonably possible that
  the total amounts of UTBs will significantly
  increase or decrease within 12 months of
  reporting date
• Disclose the nature of uncertainty (i.e. describe
  tax position)
• Disclose the nature of event that would cause the
  change
• Estimate of range of change, or statement that
  cant estimate

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The Reasonably Possible Catch-22
Its reasonably possible that Ill reverse tax
reserves in the next twelve months.
Now, Ive got you You may, after all, just need
those reserves!
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Disclosures

• Paragraph 21(d) (cont.)
• One of the more controversial areas of FIN 48
  disclosures
• Define reasonably possible
• Includes tax positions that are both recognized
  as well as not yet recognized (due to reasonably
  possible range including probabilities above and
  below MLTN).
• Nature of Uncertainty how much detail must be
  disclosed?
• Boiler-plate will not be acceptable
• Significant analysis, documentation and judgment
• All this must be performed and disclosed in the
  correct reporting period. Close scrutiny will be
  applied to evaluate the quality of the effort and
  conclusions arrived at in prior periods.
  Documentation will be an important source of
  evidence of past analysis and thought process.

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Effective Date and Transition

• Effective for FYs beginning after December 15,
  2006
• e.g., calendar year 2007 companies
• Early adoption permitted
• (provided company hasnt yet issued interim
  financials for that FY)
• Apply more-likely-than-not threshold to all
  income tax positions for all open years
• Recognize cumulative effect of applying FIN 48 as
  an adjustment to the opening balance of retained
  earnings (or other appropriate components of
  equity or net assets in the balance sheet)
• SAB 74 requires disclosure of impact of FIN 48 on
  public company financial statements

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FIN 48 Difficult Issues
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FIN 48 Difficult Issues

• Must all tax positions be evaluated for
  recognition (and correspondingly documented)?
• Said differently, are there tax positions, e.g.,
  transfer pricing, that lend themselves solely to
  the measurement test?
• Exposure draft seemed to acknowledge these issues
  were more valuation questions, where technical
  merits type of issues dont come into play.

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FIN 48 Difficult Issues

• FIN 48 defines scope to include all tax
  positions. As a matter of practicality, highly
  certain tax positions do not need to be analyzed.
  To what extent should companies document tax
  positions as being highly-certain tax positions?

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FIN 48 Difficult Issues

• To what extent should FIN 48 be implemented by
  way of a bottom-up inventory approach (i.e., by
  identifying all material tax positions for each
  open tax year for each jurisdiction) vs. a
  top-down approach (i.e., by starting with
  identified material uncertain tax positions)?

34
FIN 48 Difficult Issues

• As a result of NOLs or tax credits, the statute
  of limitations related to certain historical
  periods is often extended to align with the
  statutes for years in which attributes were
  utilized. Notwithstanding the scope of all
  possible open periods, taxing authorities often
  limit their examination to years defined within a
  particular cycle. Is it appropriate to rely on
  this administrative practice to recognize tax
  benefits in periods prior to the defined cycle?

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FIN 48 Difficult Issues

• How should a company apply the measurement
  standard to positions likely to be sustained or
  disallowed entirely (e.g., qualification for
  section 199 deduction where contract manufacturer
  relationship exists) i.e., binary issues?
• Is it possible that a position that can be
  recognized pursuant to the MLTN threshold will be
  measured such that a benefit of less than 50 is
  recorded?

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FIN 48 Difficult Issues

• To what extent may a company contemplate horse
  trading (i.e. using in measurement information
  about using one position to settle another)?
  Said differently, can an entity use aggregation
  of positions or offsetting in measuring a tax
  position?

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FIN 48 Difficult Issues

• There appears to be inconsistency between
  paragraph 10 and paragraph 12 about when entities
  should subsequently recognize, derecognize and
  measure a tax position.
• Paragraph 10 gives three situations which an
  entity can use additional information to
  subsequently recognize the benefits of a tax
  position including the tax matter is ultimately
  settled through negotiation or litigation.
• Paragraph 12 indicates that a tax position need
  not be legally extinguished and its resolution
  need not be certain to subsequently recognize or
  measure the position.

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FIN 48 Difficult Issues

• Can an entity that has a previously recognized
  position (i.e., met the more-likely-than not
  criteria) change the measurement of that position
  when a tax audit closes and the position was not
  challenged (notwithstanding the statute of
  limitation might remain open)? Assume the
  position was adequately disclosed on the tax
  return and the subject to IDRs and discussion
  with the IRS. The case went to appeals and this
  is not one of the issues as to which there is a
  proposed adjustment. Of course, there was no
  closing agreement with respect to that tax
  position.

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FIN 48 Difficult Issues

• A taxing authority completes an audit and
  requires an adjustment to a tax position that was
  not included in the companys inventory of
  uncertain tax position. The company is inclined
  to cave on this issue. Is the addition of that
  item to the inventory of uncertain tax positions
  an error or a change in estimate?

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FIN 48 Difficult Issues

• Would an entity with NOLs and a full valuation
  allowance be required to disclose any amounts in
  their unrecognized tax benefits roll-forward?
  For example, an entity has 1M RD credit
  carryforward for which 900K can be recorded by
  applying the principle of FIN 48. Would the
  entity need to reflect the 100K in the FIN 48
  tabular disclosure (notwithstanding the NOL DTA
  would not be recognized in any event due to
  valuation allowance assumptions)?

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FIN 48 Difficult Issues

• Consider a scenario where a company owns a hybrid
  flow-through entity subject to tax in a local
  jurisdiction in addition to being taxed in the
  U.S. Does the disclosure requirements of
  paragraph 21 require that a FIN 48 liability be
  disclosed to the extent that a local country
  exposure item, notwithstanding that any increased
  local tax expense would produce a corresponding
  US foreign tax credit (economically mitigating
  the risk item assuming no U.S. foreign tax
  credit limitations)?

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FIN 48 Difficult Issues

• Will entities be required to disclose the fact
  that the statute of limitations is going to
  expire in the next twelve months which will
  create a significant change?

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FIN 48 Difficult Issues

• Under FAS 123(R), there is a requirement that the
  tax benefit associated with the excess tax
  deduction be realized by reducing taxes payable.
  Since FIN 48 requires that a contingent tax
  payable be accrued, it would appear that it
  should be offset by the excess tax deductions not
  otherwise recognized (so the entry is to debit
  current tax provision and credit APIC).
• If the tax position is not later challenged or if
  the taxpayer prevails, then the APIC was never
  realized. Should it then be reversed so that the
  provision can be credited?

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FIN 48 Difficult Issues

• Can tax positions that are not individually
  significant be evaluated in the aggregate when
  the aggregated amount is material?
• Consider, for example, transfer pricing for
  commission agent or stripped buy/sell
  subsidiaries, or intercompany debt financing with
  operating subsidiaries.

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FAS 109 Common Errors
46
Tax Accounting for Business Comb. Foreign
Subsidiaries of Target

• Same general tax accounting principles apply
  deferred tax reporting for book/tax basis
  differences of inside basis assets/liabilities
• Must apply push down accounting concepts, even
  if purchase accounting adjustments maintained in
  consolidation
• In purchase accounting DTA/DTL establishment,
  imperative that appropriate jurisdictional rates
  be respected

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Jurisdictional Rate Example - Cost Sharing
Structure in Target

• Nontaxable business combination
• Acquiror (A) has a global effective rate of 30
  and a US effective tax rate of 40
• Target has a mature cost sharing structure 50
  non-US participant in Singapore
• Target (B) has 25 overall tax rate (US 40, 10
  blended non-US rate 0 rate in Caymans)
• Purchase accounting only identifiable
  intangible is product rights/IP of 40M
• WHAT RATE TO USE FOR THE PURCHASE ACCOUNTING DTL?

48
Interplay of APB23 and CTA

• For affiliates reporting in non-US FC, currency
  translation adjustments (CTA) are a component of
  OCI
• If all or a portion of unremitted earnings are
  not indefinitely reinvested under APB23, deferred
  tax reporting required on proportionate amount of
  CTA
• Recorded as a component of OCI
• Often overlooked, or complicated computations can
  be prone to errors

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Tax Effect of CTA on Unremitted Earnings

• US Tax DTL Entries
• (No APB 23 Reinvestment)
• Year 1 1 1
• Dr. DTA (FTC) 200
• Dr. Tax Provision 150
• Cr. DTL 350
• Year 2 1 1.2
• Dr. OCI 70
• Cr. DTL 70

USP
CFC
1,000 PBT 200 Tax
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Valuation Allowance- Indefinite Lived Intangibles

• Deferred Tax Liabilities
• FAS 142, Goodwill and Other Intangible Assets,
  stipulates that indefinite-lived intangibles and
  goodwill are not amortized
• FAS 109 requires recognition of deferred tax
  liabilities and assets for temporary differences
  related to intangibles and goodwill and the
  tax-deductible portion of goodwill

51
Valuation Allowance- Indefinite Lived
Intangibles

• Because indefinite-lived intangible assets and
  goodwill are not amortized, the related deferred
  tax liabilities will not reverse until some
  indeterminable future period (e.g., when the
  financial asset is impaired or disposed of)
• Due to the indeterminable reversal period of
  temporary differences related to indefinite-lived
  intangible assets and goodwill, such reversals
  normally should not be considered a source of
  future taxable income when assessing the
  realizability of deferred tax assets

52
Assumed Stock Options from Acquisition - Vested

• NQSOs deductible non-US
• Purchase accounting FV in purchase price
• No DTA (EITF 00-23)
• Tax accounting tax effect of section 83
  deduction up to fair value reduces purchase price
  (excess to APIC)

• ISOs/ESPPs, nonded non-US
• Purchase accounting FV in purchase price
• No DTA
• Tax deductible if ISO or ESPP DD
• Tax accounting tax effect of section 421(b)
  deduction to APIC

53
Assumed Stock Options from Acquisition Unvested

• NQSOs, deductible non-US
• Purchase accounting FV in purchase price
• Fair value expensed over vesting period DTA
  established (tax expense benefit)
• Tax accounting tax effect of section 83
  deduction applied against DTA, excess tax benefit
  to APIC any shortfall to APIC pool, then to tax
  expense

• ISOs/ESPPs, nonded non-US
• Purchase accounting FV in purchase price
• Fair value expensed over vesting period
  permanent difference
• Tax accounting at time of DD section 421
  deduction yields tax expense benefit up to value
  of stock-based comp charge excess to APIC

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ETR vs. Discrete
Discrete Accrual to return adjustment to the tax accounts for the prior year return
Rate Adjustment to the current period rate related to information learned from prior year return
Discrete Adjustment to tax contingency reserve specific to prior tax years
Rate Accrual of tax contingency reserve related to current year items
Rate Accrual of interest (for the current year) related to prior year tax contingencies
Discrete Accrual of penalty for prior year tax contingency
Discrete/Rate Adjustment of current year rate to incorporate changes in law or rate discrete to period that includes enactment, accrued by application of new ETR to year-to-date pre-tax income
Rate Valuation allowance required for deferred tax assets arising in the current year
Discrete Valuation allowance required for deferred tax assets existing as of the beginning of the annual period
Rate Valuation allowance release related to expected use of previously valued attributes based on current year income (assuming the current year income allowing the use of the valuation allowance is continuing operations in nature)
Discrete Valuation allowance release related to expected use of previously valued attributes based on current year income other than continuing operations (discrete tied to recognition of income allowing release of valuation allowance)
Discrete Valuation allowance release related to expected use of previously valued attributes in future periods
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Consider Tax Effects of Certain Items

• State tax is deductible
• Current deduction
• Deferred tax effect
• Interest is deductible
• Foreign tax may be creditable

56
ARB 51 Intercompany Transfer of Assets

• Under ARB51, tax expense by selling affiliate on
  intercompany transfers should be deferred
• Deferred until asset leaves consolidate group (or
  is depreciated, amortized, or impaired)
• Treated as prepaid tax, not deferred tax
• Applicable not only to inventory transfers, but
  also intangibles (e.g., buy-in payments)
• Note applicability to post-acquisition buy-ins
  if buy-in encompasses goodwill, tax expense
  deferred until impairment
• ARB51 expected to be changed in 07 in FASB
  Short-Term Convergence project

57
Classification of Valuation Allowance
Pre-Val. Allow Par. 41Allocation Par. 41Allocation FinalClassification
Reserves 1,000 1,000
Valuation Allowance (600) (600)
Subtotal - Current DTAs/DTLs (600) 400


NOLs 4,000 4,000
Depreciation (2,000) (2,000)
Valuation Allowance (2,400)
Subtotal - Noncurrent DTAs/DTLs 2,000 (2,400) (400)


Total DTAs/DTLs 3,000 (3,000) 0
58
Subsequent Release of Valuation Allowance

• Valuation Allowance established at time of
  combinations
• Tax benefits recognized subsequent to the
  acquisition are applied, in order
• Reduce to zero any goodwill related to the
  acquisition
• Reduce to zero other non-current intangible
  assets related to the acquisition
• Reduce income tax expense
• (Note FAS 141R ED proposes change)

59
Ordering of Recognition

• Generally must be specifically identified and
  recognized bases on tax return ordering
• If cannot be identified, then prorate
• Tax benefit substitution rule (Paragraph 244)
• Contrast with EITF D-32 relating to stock option
  windfall deductions

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Paragraph 244 Example
Financial Income Taxable Income
Year 1 Income (loss) from operations (4,000) (4,000)

Year 2 Income (loss) from operations 0 0
Taxable gain on sale 2,500
Taxable income before NOL 2,500
NOL from year 1 (4,000)
Taxable Income 0
61
Tax Reporting Issues with Non-US Subsidiaries

• Recording changes in deferred taxes for statutory
  rate changes in year of enactment
• Improper netting of jurisdictional deferred tax
  assets and liabilities
• Disclosure issues around non-US gross deferreds
  and valuation allowances
• APB23 deferred tax liabilities where not
  permanently reinvested
• Substantiation of EP and taxes paid pools for
  CFCs
• Adjustment for tax audits - both local and IRS
  (correlative adjs)
• Consideration of locally reported inside basis
  DTLs in deemed paid credit computation

62
Intraperiod Allocation Paragraph 140
With Without Par. 35 Par. 140
Sales 1,000,000 1,000,000 1,000,000
Expense (1,600,000) (1,600,000) (1,600,000)
Income Before Taxes (600,000) (600,000)
(assumes valuation allowance required)
Tax Provision 40,000
Net Income (6,000,000) (6,000,000) (560,000)
Other Comprehensive Income - FAS 115 Gaines 100,000 100,000
OCI Tax Effect (40,000)
Comprehensive Income (500,000) (600,000) (500,000)
63
APB 23 Background

• Not an election
• Exception applies if the specific facts and
  circumstances warrant
• Based on a companys ability and intent to
  control the reversal of a taxable temporary
  difference

63
64
APB 23 Ability Requirement

• Management representation must be supported by
  the facts and circumstances (APB 23 8)
• Financial needs of parent, and of the sub
• Remittance restrictions (legal, foreign
  jurisdiction)
• Tax consequences of the remittance
• Changes in facts and circumstances permit
  companies to justify a change in their APB 23
  position with respect to applying the indefinite
  reversal criteria.

65
65
APB 23 Management Representation

• Evidence of specific plans for reinvestment which
  demonstrate that remittance of the earnings will
  be postponed indefinitely
• Past experience considered
• Plans for future operations and remittances
  considered
• Indefinite (5-7 years is common)
• Can make different representations for different
  foreign subsidiaries

66
APB 23 - Documentation

• APB 23 contains a presumption that all earnings
  will be distributed to the ultimate corporate
  shareholder unless clear plans exist that
  demonstrate reinvestment
• Support should be documented (auditors,
  shareholders, SEC)
• Compliance With Sarbanes Oxley Section 404
  requirements

67
APB 23 Disclosure

• The following information is disclosed whenever a
  deferred tax liability is not recognized
• A description of the types of temporary
  differences for which a deferred tax liability
  has not been recognized and the types of events
  that would cause those temporary differences to
  become taxable
• The cumulative amount of each type of temporary
  difference
• The amount of unrecognized deferred tax liability
  for temporary differences related to investments
  in foreign subsidiaries or a statement that
  determination is not practicable