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The Uncertainty Principles

FIN 48 may do more than spell out how companies account for uncertain tax positions; it may also make IRS scrutiny a certainty.

September 2007
from CFO Magazine

"Sunlight is said to be the best of disinfectants," Supreme Court Justice Louis Brandeis famously said. But that was in 1914, at least a quarter of a century before the invention of sunblock and a growing awareness that too much sunlight can, in fact, be harmful. When "sunlight" is trotted out now as a metaphor to describe the benefits of expanded financial disclosures, companies don't feel cleansed so much as overexposed.

Recently they have felt positively burned. FIN 48, a set of rules that govern how companies must account for uncertain tax positions, went into effect nine months ago. (It applies to fiscal years that start after December 15, 2006.) The rules require companies to include specific information regarding potential federal and state income-tax liabilities when they report their 2007 results. Before FIN 48, information on the size of reserves maintained to satisfy potential tax liabilities was not broken out separately, but safely tucked in with other potential liabilities.

Disclosing such reserves is a boon for analysts, of course, who can never get too much information about the companies they cover. But companies are far more concerned about what another entity may do with the information. "Now everybody in the world — including the Internal Revenue Service — can see what those exposure items are in total," says one vice president of taxation at an S&P 500 company who, like other corporate financial executives contacted for this article, demanded that his name be withheld. "If you're an IRS agent and you see that a company has X number of exposure items," he says, "that really stacks the deck. The IRS can see what amounts you have set up and changes you might have made, and will start asking questions. We used to have some privacy in these matters."

Subparty On?

A strong reaction, perhaps, but not a paranoid one. Indeed, the IRS appears almost eager to start examining the enhanced financial reports that will soon head its way. At a conference in New York last spring, IRS chief counsel Donald Korb said his agents are "not going to turn a blind eye" to the tax-reserve details disclosed under FIN 48. In fact, he used this phrase at least four times during his remarks, confirming corporate tax executives' fears that the IRS will use FIN 48 as a road map to find and challenge tax-reduction strategies.

"For example," says Marian Rosenberg, a tax analyst with Thomson Tax & Accounting, "if a taxpayer shows a contingent tax liability for Subpart F income [which pertains to income from controlled foreign corporations] on its FIN 48 financial disclosure but does not show this item in its tax return, the IRS has instructed its examiners to question that."

As if providing the IRS with a road map to current delicate tax matters weren't enough, the IRS has signaled an interest in departing from its long-standing policy of not reopening tax years that have been examined and closed if information contained in FIN 48 disclosures appears to warrant a reconsideration of past decisions.

"Certain companies may be significantly affected by this new standard," says Neri Bukspan, a managing director and chief accountant at Standard & Poor's. "Companies with highly structured, tax-motivated transactions and complex operational structures, as well as those companies that have taken aggressive positions in their tax filings," are most at risk.

Bukspan ticks off some potential problems, any of which might drag down stock prices or reduce corporate credit ratings: FIN 48 could adversely affect leverage ratios, increase pressure on financial covenants that in some instances may require reworking, diminish shareholders' equity, increase contingent liabilities, and cause greater volatility in year-to-year reported earnings. So far these "side effects" have had no material affect on S&P's ratings of companies, but it's still very early days.

"FIN 48 will create a little bit of 'lumpiness' in reported earnings because of the way the statement works," Bukspan says. "Sometimes the unrecognized tax positions are recognized only upon resolution, which could occur either when the statute of limitations expires or when an audit is completed."

This is because FIN 48 encompasses a number of areas where the ultimate tax liability appears uncertain. These include claiming credits and deductions, excluding certain revenues from taxable income, and treating a merger as a tax-free transaction. Gray areas such as these have tended to elude government auditors for two reasons. First, in any given year they might not conduct an audit. Second, even if an audit is conducted, the IRS or state examiners might not notice the questionable items.

That's changed now. "Companies may no longer factor in the probability of not being audited or that the item will not be discovered in an audit," says Bukspan. "What's more, companies must now accrue interest and penalties based on the applicable tax law for the potential underpayment of taxes related to the FIN 48 liability that's recognized. This is based on the difference between the position taken in the company's tax return and the amounts reported in its financial statements."

The essence of FIN 48 — accounting for uncertainty — sounds like an oxymoron. Making it happen hinges on a two-step process. First, a company must determine if the benefit is "more likely than not" to be sustained upon audit based solely on the merits of the position. If the likelihood of being sustained is greater than 50 percent, then the company may book a benefit, though not necessarily 100 percent; if not, no benefit is recorded.

Second, in measuring the expected tax benefit, the company must assess all possible outcomes and may book only that amount with a cumulative probability exceeding 50 percent. This typically will result in a different figure from a straight probability-weighted amount.

"Most accounting standards are based on the probability-weighted amounts that will be paid," says Bukspan. "But FIN 48 requires you to use the highest amount that is likely to be realized, so the standard is somewhat unique in this regard."

In addition to some very tricky assessments and probability weightings, FIN 48 poses a good old-fashioned compliance headache in its demands for more information (see "The Dark Side of FIN 48: Putting the 'Eye' in IRS?" at the end of this article). "To gather all this data certainly will impose an additional financial burden," says one tax executive. "But I wouldn't say that it's material."

But some analysts believe that FIN 48 may trigger a domino effect on other tax-related reporting because of increased awareness by both companies and tax auditors. Take, for example, companies that employ a large number of independent contractors. Because of the heightened IRS scrutiny brought about by FIN 48, there is a greater chance that the IRS will claim that these workers are really common-law employees. Bingo: FIN 48, which applies only to income taxes, may generate an increase in payroll taxes.

In addition, FIN 48 is likely to spark more-aggressive enforcement on the state level by alerting authorities to reserves relating to state income taxes. Little wonder, then, that CFOs almost universally opposed FIN 48. "It was open for comment in 2006," says a director of financial reporting (and in fact the vast majority of the 400 letters received called for a one-year delay in implementing it, a request that the Financial Accounting Standards Board denied), "but unless FASB goes back and looks at the whole issue, I think we're stuck with it."

Says another tax executive: "Frankly, I think it's a lost cause. It's like Sarbanes-Oxley. It's something that's here to stay and we just have to learn to live with it."

Not everyone is unhappy, of course. "Because of FIN 48 we are getting a little bit more information, which as analysts we view as useful," says Bukspan. "It will take us a while to develop a time series on FIN 48 that will enable us to understand how tax positions play out over time, how earnings are affected, and what could be a more sustainable tax rate for a particular enterprise."

FIN 48 should also result in greater consistency in reporting practices by various companies. No longer will companies assume they won't be audited or that auditors will miss questionable practices, and no longer can each company create its own definition of "probable."

Like Sarbox in its early days, FIN 48 seems likely to inspire calls for more guidance and continuing complaints that it poses a greater burden than it's worth. But, like Sarbox, it appears to be largely a done deal, even if the light it casts on uncertain tax positions is still a little hazy.

© CFO Publishing Corporation 2007. All rights reserved.

Art Detman is a business writer in Pacific Palisades, California.