IT2013_1069_CH16_v2_P1_7-22

Chapter 16:

Accounting for Uncertainty in Income Taxes

Chapter Summary

In June 2006, the FASB issued guidance to address diversity in practice regarding the accounting for uncertain tax positions. The guidance standardized this area of accounting by prescribing a comprehensive two-step model that indicates how an entity should recognize and measure uncertain tax positions.

The guidance also requires disclosures specific to uncertain tax positions. Guidance issued in September 2009 eliminated certain of these disclosure requirements for nonpublic entities. All entities are required to disclose open tax years by major jurisdiction and certain information relating to reasonably possible near-term changes in the total amount of unrecognized tax benefits. The guidance also requires disclosures for all entities related to interest and penalties. In addition to these disclosures, public entities are required to provide a tabular rollforward of unrecognized tax benefits and the amount of unrecognized tax benefits, which, if recognized, would affect the effective tax rate.

16.1 Background

Significant elements of the ASC 740 model for recognition and measurement of uncertain tax benefits include the following:

Recognition threshold for recording uncertain tax benefits: A tax benefit from an uncertain position may be recognized in the financial statements only if it is more-likely-than-not that the position is sustainable, based solely on its technical merits and consideration of the relevant taxing authority’s widely understood administrative practices and precedents (Section TX 16.3).

Measurement: If the recognition threshold for the tax position is met, only the portion of the tax benefit that is greater than 50 percent likely to be realized upon settlement with a taxing authority (that has full knowledge of all relevant information) should be recorded (Section TX 16.4).

Change in judgment: The assessment of the recognition threshold and the measurement of the associated tax benefit might change as new information becomes available. Changes in conclusions for both recognition and measurement should be the result of “new information,” not a mere re-assessment of existing facts (Section TX 16.5).

Interest/Penalties: A taxpayer is required to accrue all interest and penalties that, under relevant tax law, the taxpayer would be regarded as having incurred. Accordingly, interest would begin to accrue in the same period during which it would begin to accrue under the relevant tax law. Penalties should be accrued in the first period for which a position is taken (or is expected to be taken) on a tax return that would give rise to the penalty. How an entity classifies interest and penalties in the income statement is an accounting policy decision that, once elected, must be consistently applied (Section TX 16.6).

Balance sheet classification: Liabilities for unrecognized tax benefits are classified as long-term, unless cash payment is expected within the next 12 months (Section TX 16.7).

Disclosures: ASC 740-10-50 requires qualitative and quantitative disclosures, including (1) the accounting policy classification of interest and penalties; (2) a rollforward of all unrecognized tax benefits that is presented as a reconciliation of the beginning and ending balances of the unrecognized tax benefits on a worldwide aggregated basis; (3) the amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate; (4) the amount of interest and penalties that have arisen during the year and are cumulatively accrued on the balance sheet; (5) a discussion of reasonably possible changes to the balance of unrecognized tax benefits that could occur within 12 months after the reporting date; and (6) a description of tax years that remain subject to examination by major tax jurisdictions (Section TX 16.8). Note: Guidance issued in September 2009 eliminated certain of these disclosure requirements for nonpublic entities. Section TX 15.5 includes the disclosure requirements for uncertain tax positions and identifies which are applicable to all entities and which are applicable to public entities only.

Transition and Effective Date: For public entities and nonpublic consolidated entities of public entities that apply U.S. GAAP, the guidance in ASC 740 for unrecognized tax benefits is effective for all entities, except certain investment companies,1 for annual financial statements for fiscal years beginning after December 15, 2006. For nonpublic entities that elected deferral of the guidance in ASC 740 for uncertain tax positions, it is effective in the annual financial statements for fiscal years beginning after December 15, 2008. The terms “public” and “nonpublic” entities are defined in the ASC Master Glossary.

1 On December 22, 2006, the SEC’s Office of the Chief Accountant and Division of Investment Management issued to the Investment Company Institute a letter that deferred implementation of the FASB guidance for unrecognized tax benefits for certain entities. “The SEC’s letter stated that a fund may implement the guidance in its net asset value (NAV) calculation as late as its last NAV calculation in the first financial statement reporting period required for its fiscal year beginning after December 15, 2006. For example, a calendar-year, open-end or closed-end fund would be required to implement the guidance no later than its NAV calculation on June 29, 2007 (the last business day of its semi-annual reporting period), and the effects would need to be reflected in the fund’s semi-annual financial statements, contained in its Form N-CSR filing.

Cumulative Effect from Adoption: The cumulative effect of adopting the provisions of ASC 740 for uncertain tax positions is required to be reported and presented separately as an adjustment to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that fiscal year. The cumulative-effect adjustment is the difference between the net amount of assets and liabilities recognized in the statement of financial position prior to the application of the ASC 740 guidance for uncertain tax positions and the net amount of assets and liabilities recognized as a result of applying such guidance. The cumulative-effect adjustment does not include items that would not be recognized in earnings, such as the effect of adopting the guidance on tax positions related to business combinations. For example, assume a calendar year-end nonpublic entity adopts the recognition and measurement criteria of ASC 740 for uncertain tax positions as of January 1, 2009. The company would record a cumulative effect adjustment in its financial statements as of January 1, 2009, for income tax uncertainties existing as of December 31, 2008. The effect of adjusting tax positions related to business combinations prior to the effective date of FAS 141(R) should consider the guidance that was in effect immediately prior to the effective date of ASC 805.2

2 Companies should consider the guidance in EITF Issue No. 93-7, “Uncertainties Related to Income Taxes in a Purchase Business Combination.”

16.2 Scope

ASC 740 provides guidance for recognizing and measuring tax positions taken or expected to be taken in a tax return that directly or indirectly affect amounts reported in financial statements. ASC 740 also provides accounting guidance for the related income tax effects of individual tax positions that do not meet the recognition thresholds required in order for any part of the benefit of that tax position to be recognized in an entity’s financial statements.

The guidance in ASC 740 applies to taxes (and thus uncertain tax positions) that are “based on income.” The FASB staff has stated that its intention was not to change the accounting for uncertainties related to non-income tax positions (see Section TX 16.2.1.4). Therefore, the guidance in ASC 740 related to uncertain tax positions should not be applied by analogy to non-income based taxes, such as sales taxes, value-add taxes, or property taxes.

16.2.1 Entities Within the Scope of the Recognition and Measurement Criteria of ASC 740-10-05-6

The guidance related to the recognition and measurement of uncertain tax positions within ASC 740 is applicable to business entities, not-for-profit organizations, pass-through entities, and entities (such as investment trusts and registered investment companies) whose tax liability is subject to 100 percent credit for dividends paid that are potentially subject to income taxes. It applies to all jurisdictions and all tax positions accounted for under ASC 740, regardless of the nature of the entity or taxing jurisdiction. Therefore, the requirements of ASC 740 are applicable to tax positions taken by a not-for-profit or governmental entity including those that would
affect the amount of unrelated business income taxes. The requirements of ASC 740 may also be applicable to certain S corporations that have converted from C corporation status and have deferred taxes related to built-in gains recorded.


16.2.1.1 Foreign Registrants

Foreign registrants and non-issuer foreign businesses that follow their local GAAP and present a footnote reconciling their local GAAP to U.S. GAAP for U.S. regulatory filing purposes are required to apply the recognition and measurement criteria in ASC 740 to determine net income and shareholders’ equity in accordance with U.S. GAAP. Determining whether disclosures under ASC 740-10-50-15, 50-15A and 50-19 are required depends on whether a foreign entity presents its U.S. GAAP reconciliation under Item 17 or Item 18 of Form 20-F. A non-issuer foreign business that provides a quantitative reconciliation under Item 17 of Form 20-F is not required to apply the disclosure provisions established in ASC 740-10-50-15, 50-15A and 50-19. Foreign registrants that present a U.S. GAAP reconciliation must present the reconciliation in accordance with Item 18 of Form 20-F, and therefore are required to provide the complete disclosures. Additional guidance is available in PwC SEC Volume 8010.42.

16.2.1.1.1 Non-U.S. Parent Entity

A non-U.S. parent entity may file U.S. GAAP consolidated financial statements that include both the non-U.S. and U.S. subsidiaries. The parent entity must calculate the impact of applying ASC 740’s guidance for recognition and measurement of unrecognized tax benefits for the group as a whole (i.e., for all income tax jurisdictions) because the guidance is applicable to all positions accounted for under ASC 740, regardless of the taxing jurisdictions.


16.2.1.2 Recognition and Measurement of Uncertain Tax Positions in a Business Combination

In a taxable business combination, positions may be taken in allocating the acquisition price and in filing subsequent tax returns, which are expected to be challenged by the taxing authority and perhaps litigated. Similarly, in nontaxable business combinations there may be uncertainties about the tax basis of individual assets or the pre-acquisition tax returns of the acquired business.

The recording of income-tax-related uncertainties acquired in a business combination is performed in accordance with the recognition and measurement criteria of ASC 805-740.

Adjustments to uncertain tax positions made subsequent to the acquisition date are recognized in earnings, unless they qualify as measurement period adjustments. Measurement period adjustments are recorded first as an adjustment to goodwill, then as a bargain purchase. A measurement period adjustment is an adjustment within the measurement period that relates to facts and circumstances that existed at the acquisition date.

The guidance for recognition of adjustments to acquired income tax uncertainties also applies to existing uncertainties arising in a business combination consummated prior to January 1, 2009. See Section TX 10.6 for further discussion on the treatment of income tax uncertainties in a business combination.

16.2.1.3 Separate Financial Statements

ASC 740-10-30-27 addresses separate financial statements of a subsidiary and requires that entities adopt a method for allocating taxes to the subsidiary that is “systematic, rational, and consistent with the broad principles established by this Subtopic.” Accordingly, we believe that entities should expand their accounting policies for the preparation of separate financial statements to include uncertain tax positions.

See Chapter TX 14 for guidance on accounting for separate entity financial statements.

16.2.1.4 Non-Income-Based Taxes

The guidance in ASC 740 related to uncertain tax positions is not applicable by analogy to other taxes, such as sales and use taxes, value-added taxes, or property taxes. As a general rule, sales and use taxes, value-added taxes, and property taxes do not constitute “taxes based on income” as defined by ASC 740-10-15. That said, the definition of “taxes based on income” should be interpreted broadly to include virtually any tax system that incorporates a concept of revenue minus some costs. To determine whether a particular tax is “based on income,” the laws for a given jurisdiction must be considered. For example, the Texas “Margin Tax” enacted in 2006 was determined to be an income tax accounted for under ASC 740 (Section TX 1.2 discusses how to determine whether a tax structure is based on income for the purposes of ASC 740).

Entities have historically applied ASC 450 Contingencies, to the recognition of non-income-based tax exposures (e.g., property, value-added taxes, and other taxes and governmental fees systems) that are not based on income, but are instead based on other measures, such as gross receipts, revenue, or capital. We believe that uncertainties associated with these systems should continue to be accounted for as contingencies pursuant to ASC 450.

Example 16-1: Consideration of Detection Risk When Evaluating Uncertainty in Non-Income Based Taxes

Background/Facts:

Manufacturers and importers of medical devices are subject to an excise tax on the sales price of medical devices sold in the United States. Company A, a wholly owned U.S. subsidiary of a foreign parent, is both a manufacturer and distributor of medical devices in the U.S. Company A produces Product B for sale to its customers and also buys Product C from its parent for sale to Company A’s customers.

There is uncertainty around whether Product B is subject to the excise tax since Product B is a so-called “dual use” device that has both medical and non-medical uses. Company A is taking the position that Product B is not subject to the excise tax. There is also uncertainty as to the intercompany pricing of Product C, upon which the excise tax applies.

Company A and its parent believe that it is highly unlikely that the taxing authority will examine its positions with respect to Products B and C.

Question:

Should detection risk be considered in determining whether an amount should be accrued for potential exposure associated with the positions?

Analysis/Conclusion:

When evaluating uncertainty in non-income based taxes, Accounting Standards Codification (ASC) 450, Contingencies, (ASC 450) is typically applied to determine whether a benefit or liability should be recorded. In our view, the guidance in ASC 450-20-55-14, which requires an entity to determine the degree of probability a suit may be filed or a claim asserted prior to evaluating the potential outcomes, is not applicable to a self-assessment tax system supported by provisions of existing law. Therefore, the possibility that a position will not be examined is not relevant in determining whether the position qualifies for financial statement recognition.

In this case, Company A needs to determine whether Product B is subject to the excise tax, and whether the intercompany pricing of Product C represents a fair market price.3 Company A should perform this assessment assuming the taxing authority is fully aware of the matters (i.e., without considering the risk of detection).

3 The regulations assume that the sale of the taxable article occurs in an arm’s-length transaction (that is, in a transaction between two unrelated parties) at a fair market price (i.e., the price at which the article would be sold to an independent wholesale distributor).

Company A evaluates uncertainties related to taxes other than income taxes using ASC 450 and, within that guidance, applies the loss contingencies approach. As such, if it is probable4 that Product B is subject to the excise tax or that Product C’s
intercompany price does not represent a fair market price, and the amount of the tax due can be reasonably estimated, Company A would accrue its obligation and disclose the nature and amount of the accrual. If an unfavorable outcome is probable, but the amount of the loss cannot be reasonably estimated, Company A would comply with the disclosure requirements in ASC 450-20-50-3 through 50-8. Company A would also comply with the disclosure requirements if an unfavorable outcome is not probable, but reasonably possible, and can be estimated.

4 There is some ambiguity as to whether probable should be interpreted to mean more-likely-than-not (i.e., a greater than 50 percent chance of occurring) or a higher threshold (e.g., a 75 percent chance of occurring). Although the appropriate threshold may vary according to the particular circumstances, practice generally has applied the higher threshold (i.e., roughly 75 percent) and we do not take exception to this.

16.2.2 Identifying Uncertain Tax Positions

ASC 740 offers a rather expansive definition of the term “tax position.”


Generally, entities seek to legitimately reduce their overall tax burden and to minimize or delay cash outflows for taxes by implementing tax-efficient business structures, entering into tax-advantaged transactions, and seeking tax-optimal transactions with affiliates (among other things). But even without these tax-motivated activities, the average corporate tax return will include numerous positions taken in the ordinary course of business that are subject to significant and varied interpretation (e.g., common leasing and financing arrangements, or incentive compensation).

Due to the complexities of many tax systems and today’s business environment, we believe that almost all entities will have some uncertain tax positions in open tax years. Such uncertain positions may also include issues that had no effect on the income statement, such as allocation of purchase price to assets and liabilities acquired in business combinations, issues related to share-based payment, or positions that relate to a fully reserved net operating loss (NOL) carryforward.

Entities will need to determine and assess all material positions, including all significant uncertain positions in all tax years that are still subject to assessment or challenge under relevant tax statutes. The assessment should include any position taken (or expected to be taken) on a tax return, including (1) the decision to exclude from the tax return certain income or transactions, (2) the assertion that a particular equity restructuring (e.g., a spin-off transaction) is tax-free when that position might actually be uncertain, or (3) the decision not to file a tax return in a particular jurisdiction for which such a return might be required.

16.2.2.1 Decision Not to File a Tax Return

An entity’s decision not to file a tax return in a jurisdiction where it might have nexus in a particular U.S. state or a permanent establishment in a foreign tax jurisdiction is considered a tax position.

If the entity is unable to support the technical sustainability of its position at the prescribed recognition threshold, it must recognize a liability for the realized, but unrecognizable tax benefit (i.e., by not filing and consequently not paying tax, the entity essentially realizes the benefit of taking this position). The entity must also recognize interest and any penalties, even though it has not been audited by the taxing authority. If the entity is able to support the technical sustainability of its position, it will need to measure the benefit as the largest amount that is cumulatively greater than 50 percent likely to be sustained upon settlement. If the amount measured is less than the full benefit of not filing returns, the difference is reflected as a liability.

In jurisdictions where failing to file a tax return prevents the statute of limitations from commencing, it is possible that the liability may never reverse, enabling interest and penalties to accrue in perpetuity. This would not eliminate the need to recognize a liability under ASC 740. If, when assessing nexus, the jurisdiction in question has a widely understood practice of pursuing back-taxes for a limited number of years, the entities subject to that jurisdiction should apply the “administrative practices” accommodation described in ASC 740-10-25-7(b) by accruing taxes, interest, and penalties (if applicable) for those years. Section TX 16.3.2.5 discusses the application of administrative practice and precedent to the recognition of a liability for an unrecognized tax benefit, while Section TX 16.6.2 discusses the application of administrative practice and precedent to interest and penalties.

16.2.2.2 Equity and Partnership Investments

The need to analyze uncertain tax positions is broader than analyzing the population of entities included in a consolidated set of financial statements. For example, a corporation that owns an interest in an entity that, for tax purposes, is classified as a partnership may use equity accounting to account for its partnership interest. The corporation should analyze significant uncertain tax positions that exist within the partnership since positions taken by the partnership affect both the current and deferred tax provision of the corporate partner. That is, a corporate partner’s distributive share of partnership income or loss should be the share of partnership income or loss that can be recognized by the partner pursuant to ASC 740. For example, a U.S. partnership issues Schedule K-1s to its partners and reports the partners’ distributive share of partnership income or loss. The difference between amounts reported on Schedule K-1 and amounts that should be reported pursuant to ASC 740 would represent unrecognized tax benefits.

Additionally, a reporting entity may have investments in other entities that are taxable as corporations and are also accounted for under the equity method of accounting. While the entity is not required to separately report uncertain tax positions of the equity method investee, it should consider analyzing any significant uncertain tax positions that may exist in the investee to ascertain whether those positions could affect its investment in the equity method investee. Disclosures of significant uncertainties that may affect the corporate investor’s accounting for its equity investments may be appropriate.

16.2.2.3 Uncertain Tax Positions Relating to Temporary Differences

Uncertain tax positions relating to temporary differences do not generally affect the aggregate amount of taxes payable over time; however, they can generate an economic benefit by delaying the tax payment. An example of such a position is the appropriate period of depreciation or amortization for an asset, or the appropriate fiscal year in which a clearly permissible deduction should be taken. Historically, some entities may have only accrued a liability for the interest (and possibly the penalty exposure). They may not have further analyzed the sustainability of the position because disallowance would merely result in the conversion of a deferred tax liability into a current tax payable. ASC 740 requires that such an analysis be performed at each reporting date, and ASC 740-10-55-111 through 55-112 prescribes the separation of the associated deferred tax balance into (1) the deferred tax balance based on the sustainable book/tax difference on each reporting date, pursuant to ASC 740’s recognition and measurement model, and (2) a liability for any unrecognized benefit. Section TX 16.3.2.9 provides specific examples of how to calculate deferred taxes and liabilities for unrecognized tax benefits for uncertainties relating to temporary differences.


16.3 Recognition

16.3.1 Unit of Account


The unit of account defines the level at which a tax position should be analyzed. A tax exposure could have multiple elements or parts that are interrelated with varying implications on the expected tax benefits. Therefore, the selection of a unit of account (i.e., the appropriate level of disaggregation) can affect the amount of tax benefit that may be recognized in the financial statements.

For many tax exposures, the selection of the appropriate unit of account is intuitive (e.g., company-wide cost of meals and entertainment in a taxing jurisdiction). However, for some tax exposures, such as a special deduction for qualified domestic manufacturing activities or transfer pricing, determining a unit of account can be a complex exercise that involves a number of different factors (e.g., different jurisdictions, activities, characteristics of the benefits).

The Board decided not to provide definitive application guidance on these questions, stating that facts and circumstances specific to each entity and position should be considered and that no single defined unit of account would be applicable to all situations. However, ASC 740-10-25-13 indicates that at least two factors should be considered in all situations: (1) the manner in which the entity prepares and supports its tax return and (2) the anticipated level at which the taxing authority will address issues during an examination. Therefore, to determine the appropriate unit of account, management should consider the tax return computation of a deduction, credit, or income generated by the position, including the workpapers, schedules, and technical analysis that support the calculation. An entity should also consider the audit approach that a taxing authority might take when examining the position and the entity’s audit experience related to the same or a similar position.

Exhibit 16-1: Determining the Unit of Account

ASC 740-10-55-83 through 55-86

An entity anticipates claiming a $1 million research and experimentation credit on its tax return for the current fiscal year. The credit comprises equal spending on 4 separate projects (that is, $250,000 of tax credit per project). The entity expects to have sufficient taxable income in the current year to fully utilize the $1 million credit. Upon review of the supporting documentation, management believes it is more-likely-than-not that the entity will ultimately sustain a benefit of approximately $650,000. The anticipated benefit consists of approximately $200,000 per project for the first 3 projects and $50,000 for the fourth project.

In its evaluation of the appropriate amount to recognize, management first determines the appropriate unit of account for the tax position. Because of the magnitude of expenditures in each project, management concludes that the appropriate unit of account is each individual research project. In reaching this conclusion, management considers both the level at which it accumulates information to support the tax return and the level at which it anticipates addressing the issue with taxing authorities. In this case, upon review of the four projects including the magnitude of expenditures, management determines that it accumulates information at the project level. Management also anticipates the taxing authority will address the issues during an examination at the level of individual projects.

In evaluating the projects for recognition, management determines that three projects meet the more-likely-than-not recognition threshold. However, due to the nature of the activities that constitute the fourth project, it is uncertain that the tax benefit related to this project will be allowed. Because the tax benefit related to that fourth project does not meet the more-likely-than-not recognition threshold, it should not be recognized in the financial statements, even though tax positions associated with that project will be included in the tax return. The entity would recognize a $600,000 financial statement benefit related to the first 3 projects but would not recognize a financial statement benefit related to the fourth project.


16.3.1.1 Consistency in a Tax Position’s Unit of Account

Once a unit of account for a given tax position has been determined, it should be applied consistently to that position from period to period, unless changes in circumstances suggest that a change in the analysis is warranted. Factors that might prompt management to change its assessment of the appropriate unit of account include, but are not limited to, changes in organizational structure and level of activity, changes in product line or service offering, changes in regulatory environment, and experience with the taxing authority. These types of changes would be characterized as a change in estimate.

Exhibit 16-2: Change in the Unit of Account

ASC 740-10-55-88 through 55-89

Assume that the facts outlined in Exhibit 16-1 are also true for this exhibit.

In year 2, the entity increases its spending on research and experimentation projects and anticipates claiming significantly larger research credits in its year 2 tax return. In light of the significant increase in expenditures, management reconsiders the appropriateness of the unit of account and concludes that the project level is no longer the appropriate unit of account for research credits. This conclusion is based on the magnitude of spending and anticipated claimed credits and on previous experience and is consistent with the advice of external tax advisors. Management anticipates the taxing authority will focus the examination on functional expenditures when examining the year 2 return and thus needs to evaluate whether it can change the unit of account in subsequent years’ tax returns.

Determining the unit of account requires evaluation of the entity’s facts and circumstances. In making that determination, management evaluates the manner in which it prepares and supports its income tax return and the manner in which it anticipates addressing issues with taxing authorities during an examination. The unit of account should be consistently applied to similar positions from period to period unless a change in facts and circumstances indicates that a different unit of account is more appropriate. Because of the significant change in the tax position in year 2, management’s conclusion that the taxing authority will likely examine tax credits in the year 2 tax return at a more detailed level than the individual project is reasonable and appropriate. Accordingly, the entity should reevaluate the unit of account for the year 2 financial statements based on the new facts and circumstances.


16.3.1.2 Consideration of Offsetting Positions

The unit of account of a particular tax position should be based on an individual tax position’s own information, facts, and technical merits. The possibility of offset in the same or another jurisdiction and the possibility that the position might be part of a larger settlement should not affect the determination of the unit of account.

16.3.1.3 A Single Unit of Account for Multiple Transactions That Are Similar

An entity may have multiple transactions or positions that are similar and likely to be evaluated in aggregate by the relevant taxing authority. In certain cases, management’s assessment might support one unit of account for all of the transactions combined (e.g., the unit of account is 50 similar transactions analyzed as one).

Accepting a single unit of account is possible if management, using professional judgment, concludes that the transactions are substantially the same in terms of (1) the expected tax benefits, (2) the relevant technical issues and uncertainties, and (3) the approach that a taxing authority will take during an examination (i.e., a portfolio approach). While evaluating the tax positions under a portfolio approach, a taxing authority may reject certain positions as a means of settlement because they are precluded from negotiating a settlement on an individual position. Still, as long as the related positions are substantially the same, the unit of account would be all of the transactions combined, and measurement would consider the settlement of the positions under a portfolio approach. Accordingly, the positions would be measured in aggregate, even though the expected taxing authority approach may involve disparate resolutions of individual positions in order to achieve an aggregated outcome that is consistent with the taxing authority’s discretion.

16.3.1.4 Unit of Account for Multiple Transactions That Are Dissimilar

An entity may take positions with respect to multiple transactions that require a separate unit of account for each transaction. If all of the positions meet the requirements for recognition, but the taxing authority’s settlement approach is expected to aggregate the positions (i.e., a portfolio approach), a key question arises: Can a single, combined unit of account be used for measurement if separate units of account were used for the recognition assessment?

As stated above, we believe that the unit of account should be the same for recognition and measurement of a tax position. When the appropriate unit of account is determined to be the individual transaction, the individual transaction is identified as a tax position for ASC 740 purposes, and the recognition and measurement steps should be applied to that discrete position. A taxing authority’s portfolio approach to settlement can be viewed as another possible outcome in a range of possible outcomes to be used in the measurement analysis of the greatest amount of tax benefit that is more-likely-than-not to be sustainable for each individual transaction.

For example, assume that a research credit has five individual tax positions that all meet the recognition threshold and are expected to be settled using a portfolio approach. The taxpayer expects to receive 80 cents on the dollar for those five positions in aggregate. Under this approach, 80 percent of each individual position would be separately recognized (i.e., each position is expected to be settled under a portfolio approach at 80 percent of the benefit taken on the tax return). This is acceptable if there is evidence to suggest that the relevant taxing authority has accepted such a settlement approach in the past.

16.3.2 Recognition Threshold for Uncertain Tax Positions


The tax positions identified in the above process will result (in one form or another) in a lower current or expected tax burden for the entity. The question then becomes one of recognition: When, if ever, should the tax return benefit (or expected tax return benefit) be recognized for financial reporting purposes? The following principles should be employed when assessing the recognition of the benefits from an uncertain tax position.

16.3.2.1 More-likely-than-not Recognition Threshold

For a position to qualify for benefit recognition under ASC 740-10-25-6, the position must have at least a more-likely-than-not chance of being sustained based on its technical merits, if challenged by the relevant taxing authorities and taken by management to the court of last resort.

In deciding whether a tax position meets the recognition threshold, an entity must assume that the taxing authority has full knowledge of the position and all relevant facts available as of the reporting date. That is, an entity must be able to conclude that the tax law, regulations, case law, and other objective information regarding the position’s technical merits sufficiently support the sustainability of the position’s benefits with a likelihood that is greater than 50 percent (this does not include a consideration of detection or examination risk).

If an entity decides that a particular position meets the more-likely-than-not recognition threshold, the entity essentially asserts its belief that it is entitled to the economic benefits associated with a tax position. If management cannot reach this conclusion, none of the tax benefit provided by the position can be currently reflected in the financial statements.

Management should consider a wide range of possible factors when asserting that the more-likely-than-not recognition threshold has been met. The entity’s processes should ensure that all relevant tax law, case law, and regulations, as well as other publicly available experience with the taxing authorities, have been considered.

A tax position that is supported by little authoritative guidance or case law may still have a more-likely-than-not chance of being sustained (and, thus, of being recognized) based on facts, circumstances and information available at the reporting date. The absence of specific authoritative guidance or case law does not automatically preclude a more-likely-than-not determination. Rather, other sources of authoritative tax law, although they do not specifically address the tax position, could be relevant in concluding whether a position meets the more-likely-than-not recognition threshold.

Example 16-2: The Meaning of the Term “Court of Last Resort” as Used in
ASC 740-10-55-3

Background/Facts:

State A has enacted a tax law that utilizes a nexus model, which subjects Company B to income taxes in State A. Based on the tax law as currently written in State A, Company B cannot meet the more-likely-than-not recognition threshold of ASC 740-10-25-6 based on its technical merits. However, Company B believes that it is more-likely-than-not that the tax law enacted by State A would be overturned by the U.S. Supreme Court (if heard), based on the constitutional grounds of state tax law based on an economic nexus model. Company B’s view is supported by a competent legal analysis.

In determining whether the recognition criteria is met, ASC 740-10-55-3 states that “The recognition threshold is met when the taxpayer (the reporting entity) concludes that, consistent with paragraphs ASC 740-10-25-6 through 25-7 and ASC 740-10-25-13, it is more-likely-than-not that the taxpayer will sustain the benefit taken or expected to be taken in the tax return in a dispute with taxing authorities if the taxpayer takes the dispute to the court of last resort.” Company B believes that the court of last resort would be the U.S. Supreme Court, as this is the highest court that could potentially hear its case.

Question(s):

Question #1

Should Company B consider the U.S. Supreme Court to be the court of last resort, even though it is unlikely that the Supreme Court would ultimately agree to hear the case?

Question #2

Should Company B factor the state tax law being overturned by the U.S. Supreme Court into its application of the recognition step?

Analysis/Conclusion:

The conclusions provided below have been developed based on informal guidance provided by the FASB staff.

Question #1

Yes. Because, in this fact pattern, the U.S. Supreme Court is the highest court that has discretion to hear a case surrounding the constitutionality of an enacted state law, Company B’s conclusion that it is the court of last resort is appropriate. ASC 740-10-25-6 states that “the terms examined and upon examination also include resolution of the related appeals or litigation processes, if any.” Since the litigation process would include the ability to appeal whether a tax law conflicts with a higher level law, that appeal and the resultant outcome should be considered in assessing compliance with the more-likely-than-not criterion for initial recognition. As a result, when determining the appropriate court of last resort as part of ASC 740-10-25’s recognition step, companies should focus on identifying the highest court that has discretion to hear the specific case in question, even though that court may not ultimately hear the case.

Question #2

Yes. In considering the litigation process, Company B would include an assessment based on the technical merits of whether the issue is in conflict with federal law. As a result, the technical analysis of whether State A’s tax law would be overturned by federal law should be considered in assessing the more-likely-than-not recognition criteria.

Given the number of cases that are filed with the U.S. Supreme Court, a question arises as to whether or not Company B would need to assess the likelihood of its case ultimately being heard by the court of last resort in the recognition step. We believe that a denial of a request for a hearing by the court of last resort is considered company specific and not dispositive of the technical issue in question. Therefore, while the court of last resort may deny a request to hear a company’s case, the denial would not affect another company’s previous conclusion regarding whether its tax position met the recognition threshold. Our view is supported by the FASB staff’s view that Company B should not factor this assessment into the recognition step, but should instead consider it within the context of the measurement step. That is, the individual probabilities for determining the greatest amount of tax benefit that has a greater than 50 percent probability of being realized should consider the likelihood that the U.S. Supreme Court will agree to hear the case. We would generally expect companies arguing that a state tax law is unconstitutional to record only a tax benefit associated with that tax position if the cumulative probability of a settlement with the state taxing authority is greater than 50 percent. Therefore, if the state tax jurisdiction is unwilling to settle the tax position with the company and it is less than 50 percent likely that the U.S. Supreme Court will hear the case, the company may need to establish a liability through application of the measurement step for the entire unrecognized tax benefit.


16.3.2.2 Sources of Authoritative Tax Laws

Sources of tax authority that should be considered in determining whether an uncertain tax position meets the recognition threshold under ASC 740-10-25 vary depending on the jurisdiction (federal, state, or foreign) within which a tax position arises. In general, relevant sources include statutes (including the underlying legislative intent), regulations, certain taxing authority rulings, case law, and treaties. For U.S. federal income tax purposes, those authorities in general include, but are not limited to, the following:

Internal Revenue Code (IRC) and other statutory provisions.

Regulations interpreting such statutes.

Revenue Rulings, Revenue Procedures, Notices, and Announcements.

Tax treaties and regulations thereunder and Treasury Department and other official explanations of such treaties.

Court cases.

Congressional intent as reflected in committee reports, joint explanatory statements and floor statements made by one of the bill’s managers.

General explanations of tax legislation prepared by the Joint Committee on Taxation (the “Blue Book”).

Internal Revenue Service information or press releases.

Pronouncements published in Internal Revenue Bulletins.

Private Letter Rulings (PLRs), Technical Advice Memoranda (TAMs), Chief Counsel Advice, Field Service Advice, and similar documents.

When determining whether recognition has been satisfied, consideration should be given to the weight of the particular authorities cited in relation to the weight of authorities supporting contrary treatment and the authorities’ relevance, persuasiveness and the types of document providing the authority. Also, an authority does not continue to be an authority to the extent that it is overruled or modified by a body with the power to overrule or modify the authority.

In the U.S., when a tax position arises in a state or local jurisdiction, Public Law (P.L.) 86-272, which governs state nexus requirements in interstate commerce, and any similar federal laws governing interstate commerce are considered authoritative, in addition to the particular state’s tax statutes and regulations. When a tax position arises in a foreign jurisdiction, continental business and tax legislation (e.g., the European Union Directives that govern taxation of cross-border flow of, among other things dividends, royalties, and interest within member states) may, depending on the jurisdiction, also be considered authoritative.

In addition, certain rulings and agreements if issued to the taxpayer by the taxing authority would typically form the basis for meeting the recognition threshold, provided the decision therein is favorable to the taxpayer and if the facts and representations that form the basis of the ruling are complete and accurate. These authorities include, for example:

Private Letter Rulings or a Technical Advice Memorandum.

Advance Pricing Agreements (APAs), which are entity-specific transfer pricing agreements with the taxing authority.

Competent Authority resolution, which is a formal agreement between the taxing authorities of two countries interpreting provisions in a bilateral income tax treaty for the elimination of double taxation applicable to entity-specific facts and circumstances.

Pre-filing agreements.

As it relates to taxpayers who were not a party to the ruling or agreement, such rulings/agreements are generally not binding on the taxing authority and are of more limited authority.

16.3.2.3 Tax Opinions and External Evidence

Management will also have to determine whether the entity has sufficient internal resources to appropriately assess an uncertain tax position or whether the entity will need support from third parties to make this assessment (e.g., opinions from external tax advisors).

ASC 740-10-25-6 acknowledges that the “level of evidence that is necessary and appropriate to support an entity’s assessment of the technical merits of a tax position is a matter of judgment that depends on all available information.”

Whether management decides to obtain a tax opinion to affirm the sustainability of a position based on its technical merits depends, among other things, on the significance (i.e., the nature and complexity) of a tax position taken or expected to be taken on a tax return. A large number of tax positions will have clear support in the tax law and will not require substantial documentation efforts to satisfy the recognition assessment. For example, the deductibility of certain noncash expenses might not relate to whether the taxpayer is entitled to the position, but to the amount of benefit and the appropriate tax period(s) (i.e., measurement). However, there will also be a number of positions that require management to expend a significant amount of time and energy gathering evidence in support of its more-likely-than-not assertion.

Where appropriate, management should document its conclusion, including the information and factors considered, how those factors were weighted, and which factors might be particularly susceptible to change. Those factors most susceptible to change should be monitored closely.

An entity that obtained a more-likely-than-not opinion from an outside tax advisor in an earlier financial reporting period may need to consider the relevancy of the opinion to the current-period assessment and whether the tax opinion needs to be reissued. As stated above, ASC 740-10-25 does not require a more-likely-than-not tax opinion for determining whether a tax position meets the technical merits of a tax law. However, in certain situations, a more-likely-than-not opinion may need to be obtained. In those circumstances, if there has been no change to the relevant tax laws or other relevant factors/information that existed at the time when the tax opinion was first written and upon which the opinion is based, the opinion letter would not need to be reissued. If, however, new information or developments that could affect the position become available, and/or changes in tax laws, regulations, and interpretations that might affect the position have occurred since the time at which the original opinion was written, a new or updated opinion may be necessary.

PwC engagement teams are required to consult with Assurance Risk Management within PwC’s National Professional Services Group in situations where an outside tax advisor has provided the client with a written analysis or opinion, and the client is proposing either to limit our access to the complete, un-redacted material or to restrict what we may require for documentation.

16.3.2.4 Examination by Taxing Authority (Detection Risk)

ASC 740-10-25-7 and ASC 740-10-30-7 require an entity to assume, in assessing both recognition and measurement, that an uncertain tax position will be discovered by a taxing authority and that the taxing authority will examine the position with access to all relevant facts and information using resources that have sufficient experience and expertise in the area of tax law creating the uncertainty. ASC 740’s recognition and measurement guidance requires entities to presume that a taxing authority has full knowledge of a position, even if the entity has no history of being examined by taxing authorities or the chance of the taxing authority actually identifying the issue (if it were to conduct an audit) is remote.

16.3.2.5 Administrative Practices and Precedents

The assessment of sustainability is based on the technical merits of the position, including consideration of “administrative practices and precedents” (ASC 740-10-25-7(b)). Administrative practices and precedents represent situations in which a tax position could be considered a technical violation of tax law. However, it is widely known, well understood, and a consistent practice of the taxing authority (with full knowledge of the position being taken) to nonetheless accept the position. When asserting that a particular administrative practice or precedent is applicable to a particular tax position, an entity should presume that the taxing authority will examine the position using the same information that is available to the entity.

While administrative practices and precedents do not need to be sanctioned by taxing authorities in formal regulation or letter ruling, it should be clear (through the taxing authorities’ well-known past actions or declarations) that a tax position is more-likely-than-not to be sustained (if examined), despite its apparent conflict with the enacted tax law. Unless it becomes known that the taxing authority will no longer accept a particular administrative practice, preparers should consider these practices in forming their conclusions as to whether a position has satisfied the recognition threshold.

Exhibit 16-3 describes an administrative practice related to asset capitalization.

Exhibit 16-3: Administrative Practice Related to Asset Capitalization

ASC 740-10-55-91 through 55-92

An entity has established a capitalization threshold of $2,000 for its tax return for routine property and equipment purchases. Assets purchased for less than $2,000 are claimed as expenses on the tax return in the period they are purchased. The tax law does not prescribe a capitalization threshold for individual assets, and there is no materiality provision in the tax law. The entity has not been previously examined. Management believes that based on previous experience at a similar entity and current discussions with its external tax advisors, the taxing authority will not disallow tax positions based on that capitalization policy and the taxing authority’s historical administrative practices and precedents.

Some might deem the entity’s capitalization policy a technical violation of the tax law, since that law does not prescribe capitalization thresholds. However, in this situation the entity has concluded that the capitalization policy is consistent with the demonstrated administrative practices and precedents of the taxing authority and the practices of other entities that are regularly examined by the taxing authority. Based on its previous experience with other entities and consultation with its external tax advisors, management believes the administrative practice is widely understood. Accordingly, because management expects the taxing authority to allow this position when and if examined, the more-likely-than-not recognition threshold has been met.


16.3.2.5.1 Administrative Practices and Precedents Available to Entities
That Self-report

Many jurisdictions offer amnesty programs or limit the tax they assess in past periods for taxpayers that have voluntarily come forward and admitted noncompliance in previous years. However, the administrative practice or precedent that may be available to self-reporting entities for nexus-related issues may not be available to those entities that fail to come forward and are subsequently identified by the taxing authority. Accordingly, it would not be appropriate for an entity that has no intention of coming forward to consider an administrative practice made available to those that do come forward, unless there is substantial evidence that both types of taxpayers will be treated the same way by the taxing authority.

The same concept may also apply to REITs and regulated investment companies (RICs) which have uncertain tax positions that could affect their qualification for special treatment under the relevant tax law. These specialized entities can often cite experience with taxing authorities and describe how those authorities have historically handled inadvertent, self-reported disqualifying events that could have led to the entity’s disqualification as a REIT or RIC. However, entities with no intention of self-reporting cannot rely on administrative practices or precedents related to the taxing authorities’ historical treatment of self-reporting entities. Entities with no intention of self-reporting can only rely on the taxing authorities’ practices for handling disqualifications identified during an audit, and only if those practices are widely understood and consistently applied.

16.3.2.5.2 Nexus-Related Administrative Practices and Precedents

In general, an entity may have some form or combination of legal, structural, or commercial ties to a jurisdiction (e.g., employees, inventory, fixed assets, commissionaire arrangements, contract manufacturing arrangements, and others). An entity with such ties could potentially have nexus, and would therefore be required to file a tax return under the tax laws of the relevant jurisdiction. ASC 740-10 defines a tax position in part as “A decision not to file a tax return.” Absent an applicable administrative practice, a nexus position (i.e., a decision not to file a tax return in a particular jurisdiction if nexus potentially exists) that does not meet ASC 740-10-25-5’s recognition threshold would require the accrual of tax, interest, and penalties for the entire period in which nexus could be asserted by the taxing authority.

However, as a matter of administrative convenience, some jurisdictions have limited the number of years for which an entity would be required to file back tax returns. Under ASC 740-10-25-7, that practice should be considered in management’s decision to record tax, interest, and/or penalties.

ASC 740-10-55-94 through 55-95 provide the following example about the use of administrative practices and precedents within the context of nexus.

Exhibit 16-4: Administrative Practices Related to Nexus Positions

ASC 740-10-55-94 through 55-95

An entity has been incorporated in Jurisdiction A for 50 years; it has filed a tax return in Jurisdiction A in each of those 50 years. The entity has been doing business in Jurisdiction B for approximately 20 years and has filed a tax return in Jurisdiction B for each of those 20 years. However, the entity is not certain of the exact date it began doing business, or the date it first had nexus, in Jurisdiction B.

The entity understands that if a tax return is not filed, the statute of limitations never begins to run; accordingly, failure to file a tax return effectively means there is no statute of limitations. The entity has become familiar with the administrative practices and precedents of Jurisdiction B and understands that Jurisdiction B will look back only six years in determining if there is a tax return due and a deficiency owed. Because of the administrative practices of the taxing authority and the facts and circumstances, the entity believes it is more-likely-than-not that a tax return is not required to be filed in Jurisdiction B at an earlier date and that a liability for tax exposures for those periods is not required.

16.3.2.5.2.1 Application of Administrative Practices to U.S. State Jurisdictions

In many U.S. state jurisdictions, we understand that state and local tax experts would commonly agree that states only seek back taxes for a defined period of time if the number of open years is significant and if a reasonable position can be asserted by the taxpayer that nexus did not exist and that fraud was not present. Yet, although the practice of limiting years of assessment is widely known, the period of assessment that a respective taxing authority will ultimately choose is not. That determination is often made only after the taxing authority has considered the individual facts and circumstances of a specific taxpayer.

When a taxing authority has a history of assessing tax on a limited number of years and when that practice is widely understood, we believe that an administrative practice and precedent (as described in ASC 740-10-25-7) exists. For example, if state tax experts agree that a range of years (depending on the taxing authority’s assessment of the facts and circumstances) reflects the taxing authority’s practice with respect to the period of assessment, an administrative practice exists. Further, we believe that there is a rebuttable presumption that the upper limit of such a range should be considered the relevant administrative practice. Use of a data point that is from the low end, and not the high end, of the range would require convincing evidence as to why an entity’s fact pattern warrants this consideration. The following example illustrates the application of administrative practices in a U.S. state scenario.

Example 16-3: Application of U.S. State Administrative Practices

Background/Facts:

Assume that a state jurisdiction has an administrative practice of limiting the assessment of taxes to three to six years if nexus within that jurisdiction is unclear. However, if nexus is clear, it is widely understood that the taxing authority will assess taxes for up to ten years.

Analysis/Conclusion:

In evaluating whether a tax return should have been filed for any of those years, we believe that each tax year would represent a separate unit of account. That is, each year should be separately analyzed to determine whether a tax return should have been filed and whether a tax exposure exists for that year. In making this determination, an entity would consider the relevancy of a taxing authority’s administrative practices.

If convincing evidence causes an entity to conclude that nexus within that jurisdiction was unclear, the entity should recognize the assessment of income taxes on a rolling six-year basis. Further, if the entity believes that its tax exposure is less than six years (e.g., three years), it would need to have convincing evidence in support of that view. This rationale should not include the entity’s ability to negotiate with the taxing authority. Rather, the position should be consistent with a widely understood practice for assessing the tax exposure at the lower end of the range for the particular circumstance (e.g., based on limited activity within the taxing jurisdiction).

16.3.2.6 Assessing Recognition When Potentially Offsetting Positions Exist

ASC 740-10-25-7 requires that each tax position be evaluated on, among other things, its own information, facts, and technical merits, without consideration of the possibility of offset or aggregation of other. For instance, a corporation must separately assess for recognition each known, significant uncertain tax position, even if the corporation expects that it will prevail on one position because it expects to settle another related tax position.

16.3.2.7 Assessing Recognition When Potentially Indirect Benefits Exist

A liability recorded for one position may cause a tax benefit to be recognized on another position. The resulting indirect benefit of the latter position should not affect the need to separately assess the recognition of a liability on the first tax position. For example, an uncertain tax position taken in a foreign jurisdiction must be separately assessed for recognition of a liability, even though the resulting liability would give rise to a foreign tax credit (FTC) benefit in the parent jurisdiction. The example below discusses the accounting for indirect effects (i.e., benefits) arising in a jurisdiction that is not the same jurisdiction in which the liabilities arise.

Example 16-4: Federal Effects of Unrecognized Tax Benefits Related to State Taxes

Background/Facts:

Company A, a public entity, has taken an uncertain tax position in State X that reduces taxes payable (or increases a tax refund receivable) by $100. In assessing the uncertain tax position under the recognition and measurement criteria of ASC 740, Company A has determined that it is more-likely-than-not that the position, based on its technical merits, will be sustained upon examination. In performing the measurement step in ASC 740-10-30-7, Company A determined that $60 is the largest tax benefit that is greater than 50 percent likely to be realized upon ultimate settlement with the taxing authority. Therefore, Company A has recorded a liability of $40 for the unrecognized tax benefit in State X.

If Company A is ultimately required to make an additional payment of state taxes, it will receive an additional federal tax deduction, the benefit of which is expected to be fully realized under the recognition and measurement principles of ASC 740.

Question:

Should Company A record an asset for the federal tax deduction related to the liability on an unrecognized tax benefit in State X?

Analysis/Conclusion:

Yes, Company A should record a deferred tax asset (or potentially a current tax receivable depending on the facts and circumstances) for the federal indirect benefit from the potential disallowance of the uncertain tax position in State X. Assuming that the federal tax rate is 35 percent, the following journal entries would be made to account for the uncertain tax position and the indirect tax benefit:



The deferred tax asset associated with the indirect federal benefit should not be used to offset the liability on the state tax exposure, as discussed in the last sentence of ASC 740-10-45-11. This conclusion is also supported by ASC 740-10-45-6, which indicates that tax assets and liabilities related to a particular tax-paying component and within a particular tax jurisdiction should not be offset. In addition, the unrecognized tax benefit related to the state exposure should be included on a gross basis (i.e., not net of the federal benefit) in the annual tabular reconciliation required by ASC 740-10-50-15A(a).

Further, the tax exposures in one jurisdiction should be evaluated separately from the indirect benefit in another tax jurisdiction, as the accounting for the tax exposure in one jurisdiction will not necessarily correlate to the benefit from the other jurisdiction. For example, a valuation allowance on the indirect benefit or a change in tax laws/rates in either of the jurisdictions may be needed. Additionally, the related interest in one jurisdiction may be different from the interest in another jurisdiction.

16.3.2.8 Uncertainties Regarding Valuation

For tax positions where the uncertainty is based solely on a transaction’s value (e.g., transfer pricing, value of goods donated, etc.), we believe that the recognition threshold has been met if it can be concluded that some level of tax benefit in the year in which the transaction occurred meets the more-likely-not recognition threshold. If the recognition threshold is met, the uncertainty associated with the transaction’s valuation should be addressed as part of measurement. For example, an entity may donate shares in a privately held company to a charity and claim a tax deduction. If the entity’s deduction is certain (based on the position’s technical merits), the tax benefits can be recognized. However, the deduction amount may be uncertain because of complexities surrounding the appropriate fair market value of the donated shares. In the measurement step (discussed in Section 16.4), the entity should consider this valuation uncertainty in determining the greatest amount of tax benefit that is sustainable.

16.3.2.9 Timing Differences

Chapter TX 3 discusses temporary differences. As explained in Chapter TX 3, ASC 740 defines a temporary difference as the difference between the tax basis of an asset or liability computed pursuant to the requirements in ASC 740-10 for tax positions and its reported amount in the financial statements. ASC 740’s recognition and measurement criteria is applicable to temporary differences between book and tax bases, even if the only uncertainty is the timing of the position taken for tax purposes. For example, assume that an entity deducts (for tax purposes) the entire balance of an intangible asset in the year of an acquisition. For book purposes, the entity amortizes the intangible asset over five years (this consequently leads to a deferred tax liability). While the ultimate deduction of the asset is certain under the relevant tax law, the timing related to whether the deduction can be taken in full in the year of the acquisition is uncertain.

At the AICPA National Conference on Current SEC and PCAOB Developments held on December 11-13, 2006 (AICPA Conference), the FASB staff stated that uncertain tax positions that relate only to timing (i.e., when an item is included on a tax return) should be considered to have met the recognition threshold for the purposes of applying ASC 740-10-25-5. Therefore, if it can be established that the only uncertainty relates to the tax period(s) in which an item is taken on a tax return, it can be concluded that the positions have satisfied the recognition step for the purposes of applying ASC 740-10-25 and any uncertainty related to timing should be assessed as part of the measurement step.

It is our understanding, based on discussions with the FASB staff, that ASC 740-10-55-110 through 55-116 should be used to understand the intent of the standard pertaining to timing-related uncertainties. These paragraphs indicate that timing-related uncertainties meet the recognition threshold because those items will ultimately be deductible.

For example, assume that an entity had a bonus accrual and took a deduction on the current-year tax return, even though the bonus accrual was not paid out within the appropriate time frame for it to be considered a current-year deduction from a tax law perspective. Presumably, the entity would be able to conclude that the amounts are ultimately deductible (when paid) and, as such, would meet the recognition threshold. In the FASB staff’s view, the entity would not need to evaluate whether there was a basis within the tax law to accelerate the deduction on the tax return for purposes of applying the recognition step under ASC 740-10-25-5. Rather, an entity would need to determine the largest tax benefit that is cumulatively greater than 50 percent likely to be realized for the purposes of recognizing the amount of tax benefit in the financial statements. Nonetheless, in assessing the various outcomes and related probabilities as part of the measurement step, we believe that entities will need to consider the technical merits of the relevant position(s), particularly if those positions have not been settled with the taxing authority in the past.


The following example illustrates how ASC 740 recognition and measurement can affect the calculation of deferred taxes (Note that this example is based on the concept illustrated in ASC 740-10-55-110 through 55-112, which are included in Section TX 16.4 of this chapter).

Example 16-5: Recognition of Timing-Related Uncertain Tax Positions

Background/Facts:

Company A incurs $100 in repairs and maintenance expenses. For financial statement purposes, Company A expenses the costs in the year during which it incurs the costs. In addition, Company A plans to take the entire $100 as a deduction on its current-year tax return. However, Company A concludes that only $25 of the deduction meets the recognition threshold and measurement criteria in the current year. That is, Company A believes that the largest benefit that is greater than 50 percent likely to be realized is straight-line amortization over four years. Therefore, if the as-filed tax position (i.e., the full deduction claimed in the current-year tax return) is not sustained, Company A would be entitled to the remaining $75 of deductions over the next three years. Company A is a profitable taxpayer in the current year, and has a 40 percent tax rate in this jurisdiction.

Question:

How should Company A compute its liability for unrecognized tax benefits and calculate its deferred taxes?

Analysis/Conclusion:

The measurement and calculation of temporary differences and deferred taxes are based on the difference between the tax basis of an asset or liability computed pursuant to ASC 740’s recognition and measurement criteria and its reported amount in the financial statements. For financial reporting purposes, Company A has no book basis in the asset because it fully expensed the associated costs. Yet, Company A does have a tax basis computed under ASC 740, although it deducted the entire cost on the current-year tax return. The tax basis computed under ASC 740 is $75 (i.e., the cost of $100 less the current-year recognized tax benefit of $25). At the reporting date, Company A has a $75 deductible temporary difference, which is the difference between the tax basis computed under ASC 740 (or $75) and the book basis (or zero). Company A would record the following journal entry:


The journal entry above records (1) the reduction of a $40 income taxes payable for the $100 maintenance deduction ($100 at a 40 percent tax rate), (2) a current tax benefit for the tax effect of the deduction taken on the tax return that meets the recognition and measurement criteria of ASC 740 ($25 at a 40 percent tax rate), and (3) a liability for the tax effect of the amount deducted on the tax return that did not meet the recognition and measurement criteria of ASC 740 ($75 at a 40 percent tax rate).

The following additional journal entry records the deferred tax asset (DTA) for the expected future deductible amount associated with the repairs and maintenance costs ($75 at a 40 percent tax rate) as determined pursuant to ASC 740’s recognition and measurement criteria (i.e., straight-line amortization over four years, with three years remaining as of the end of the current year).



Finally, Company A would also need to consider whether interest should be accrued on the liability for the unrecognized tax benefit.

16.3.2.10 Amended Returns and Refund Claims

Although an uncertain tax position is most commonly associated with a tax reserve or the decrease of a tax asset, it can also be associated with cases that result in an increase of a tax asset (e.g., a tax receivable recorded as a result of the filing or the intent to file an amended return).

An entity may be in the process of preparing amended returns to claim refunds on taxes paid in prior periods, but may be unable to file the amended returns before the end of the accounting period or before it files the current-period financial statements. If this is the case, all significant tax positions expected to be included in the amended returns or refund claims should meet the recognition threshold before the expected tax benefit (i.e., the refund receivable) can be recognized in the financial statements.

There may be instances in which an entity’s expectations and intentions regarding an amended return or refund claim are unclear. Such situations may require the use of professional judgment to determine whether, or to what extent, the amended return or refund claim is within the scope of ASC 740’s recognition and measurement criteria.

ASC 740 is applicable to all tax positions that were included on previously filed returns and are expected to be included on returns that have not yet been filed (e.g., amended returns or refund claims that have not yet been filed). The timing of the filing of a tax return is irrelevant, as long as a tax position taken or expected to be taken ends up on an original, amended, or so-called “protective” return.

Therefore, when a refund claim or an amended return fails the requirement for recognition, the expected tax benefit (i.e., refund receivable) cannot be recognized in the financial statements. A refund receivable that is recognized in the financial statements in a prior period, but is determined to fail the recognition threshold in the current period would be derecognized in the financial statements (i.e., the tax receivable asset would be eliminated or reversed). That is, because the recognition threshold has not been met, nothing would be recognized in the balance sheet for this refund claim. However, the amount of the refund claim would still be included as an unrecognized tax benefit in the disclosures required under ASC 740-10-50-15.

Moreover, courts in some jurisdictions require payment of taxes in question as a prerequisite to petition the court. In the past, some entities may have viewed the potential recovery of such amounts as a gain contingency under ASC 450 and may have consequently expensed any amounts paid. However, it should be noted that ASC 740 applies to this type of tax payment. If the taxpayer’s position meets the recognition threshold (and no reserve is required in the measurement step), the taxpayer should record an asset for the prepaid tax and accrue interest income (if applicable).

Furthermore, in the U.S., during an IRS examination, taxpayers may present claims for additional tax benefits that were not reported on the original tax return under examination. Such claims generally arise from new information that was not available when the original return was filed. The IRS policy allows for claims to be directly submitted without requiring the filing of an amended return. However, documentation supporting the basis for the claims and the resulting impact on tax liability must be presented to the IRS during the examination process.

Such claims constitute tax positions subject to ASC 740’s recognition and measurement principles. If the application of ASC 740 would result in no or partial benefit being reported for the claims, an uncertain tax benefit must be disclosed in the rollforward tabular reconciliation until the tax benefits can be recognized or the statute closes. The disclosure requirement begins when a taxpayer decides to present claims for additional tax benefits (refer to Section TX 15.5 for additional discussion on disclosure requirements for uncertain tax benefits).

16.3.2.11 Interaction with Valuation Allowance Assessment

The recognition of an additional tax liability as a result of an uncertain tax position and its impact on deferred taxes must be distinguished from the assessment of the need for a valuation allowance under ASC 740-10-30-16 through 30-25. The recognition of a liability for an unrecognized tax benefit stems from uncertainty about the sustainability of a tax position taken or expected to be taken on a tax return. The recognition of a valuation allowance stems from uncertainties related to whether taxable income will prove sufficient to realize sustainable tax positions. That is, uncertainties about sustaining tax positions relate to whether a tax liability or deferred tax asset exists. Uncertainties about sufficient taxable income relate to the realization of recorded deferred tax assets. Therefore, valuation allowances may not be used to reserve for uncertain tax positions.

Example 16-6: Establishing a Liability Upon Adoption of the ASC 740 Guidance for Unrecognized Tax Benefits When a Company Has a NOL with a Valuation Allowance

Background/Facts:

Company A is a non-public entity that has a full valuation allowance on all of its deferred tax assets, including its NOL. On January 1, 2009, the company adopted the ASC 740 guidance for unrecognized tax benefits and appropriately determined that certain tax positions do not meet the recognition and measurement thresholds. As a result, the company recognized a liability of $1,000. The company did not take these tax positions in the years in which the NOLs were created, but instead it took these tax positions, which relate to the liability, in years that generated taxable income (i.e., taxable income before NOL utilization). Accordingly, the company recorded the liability separately from the DTA associated with the NOLs (i.e., gross, as opposed to net, of the NOL-related DTA). Upon adoption, Company A also determined that $1,000 of the valuation allowance on existing DTAs will no longer be necessary because the incremental taxable income would be a source of income for the existing DTAs if the tax position is not sustained.

Question:

How should Company A account for the release of the valuation allowance on its existing deferred tax assets due to the creation of a liability for the unrecognized tax benefits upon adoption?

Analysis/Conclusion:

In general, the release of the valuation allowance caused by the establishment of the liability should be accounted for as part of the adoption process as an adjustment to beginning retained earnings. This means that there will not be a net effect to retained earnings because the reduction in opening retained earnings associated with establishing the liability will be offset by an increase in opening retained earnings associated with the release of the valuation allowance. This accounting is consistent with ASC 740-20-45-11(a), which states, in part, that tax effects such as “adjustments of the opening balance of retained earnings for certain changes in accounting principles” should be charged or credited directly to the related components of shareholder’s equity.

There is, however, an exception to this general approach if the valuation allowance was originally established in a business combination (i.e., if it relates to acquired NOLs or temporary differences) or in a reorganization subject to “fresh start” accounting under ASC 852 Reorganizations. In these instances, we believe that the release of a valuation allowance, even though it is a direct effect of the change in accounting principle, is subject to “backwards tracing” pursuant to ASC 740-20-45-3 (i.e., as an adjustment to the acquisition accounting or reorganization accounting).

Although ASC 805 amended the guidance for subsequent changes in valuation allowances and uncertain tax positions related to prior business combinations, the pre-ASC 805 guidance was still applicable as of December 31, 2008. The cumulative-effect adjustment upon adoption of the ASC 740 guidance for unrecognized tax benefits should be the difference between the net amount of assets and liabilities recognized in the statement of financial position as of December 31, 2008, prior to the application of the guidance and the net amount of assets and liabilities recognized as a result of applying the guidance. Therefore, the guidance that was in effect prior to adoption of ASC 805 should be considered.

When determining the amount of valuation allowance to release, companies should also consider whether the NOLs were the result of windfall tax benefits (e.g., from stock options accounted for prior to the effective date of ASC 718). In this circumstance, the amounts would need to reduce taxes payable before any valuation allowance reversal can be recognized (as discussed in ASC 718-740-25-10). That is, in the case of NOLs that represent windfall tax benefits, even though the offsetting income from the uncertain tax position would constitute a source of income for the NOL, no valuation allowance reversal could be recorded until such NOLs were utilized currently on a tax return.

It should be noted that the accrual of interest on the liability for the unrecognized tax benefit may prove unnecessary to the extent that increased tax on positions that are unsustainable can be offset by existing NOLs.

16.3.2.11.1 Tax-Planning Strategies


If an entity uses a tax-planning strategy (as defined in ASC 740-10-30-19) that is considered to be a possible source of future taxable income, the entity must apply ASC 740’s recognition and measurement criteria to the tax-planning strategy to determine whether the expected tax consequence can be recognized in the financial statements. Tax-planning strategies that, based on their technical merits, do not meet the more-likely-than-not recognition threshold upon examination cannot be used to reduce the valuation allowance on deferred tax assets. Only a tax-planning strategy that meets the more-likely-than-not recognition and measurement criteria should be considered a source of future taxable income in a valuation allowance assessment (ASC 740-10-55-98).

16.4 Measuring the Tax Benefit to Be Recorded


After concluding that a particular filing position has a more-likely-than-not chance of being sustained, ASC 740-10-30-7 requires that an entity measure the amount of benefit to be recognized using a measurement methodology that is based on the concept of cumulative probability. Under this methodology, the amount of benefit recorded represents the largest amount of tax benefit that is greater than 50 percent likely to be realized upon settlement with a taxing authority that has full knowledge of all relevant information.

The analysis that needs to be performed and the level of documentation that needs to be created will vary based on the significance and complexity of the issue, as well as the degree of perceived uncertainty in the tax law. In some cases, this may require entities to develop a cumulative probability table. In other cases, this may not be necessary. Whether documentation is considered sufficient will depend on whether one can conclude, based on existing documentation, that the benefit recorded is the outcome that represents the largest amount of tax benefit that is greater than 50 percent likely to be realized upon effective settlement.


16.4.1 The Cumulative Probability Approach

ASC 740 does not define “cumulative probability,” however, the term is included in the measurement examples provided in ASC 740-10-55-102 through 55-107. When more than two outcomes may alternatively resolve an uncertain tax position (i.e., resolution may occur other than on an “all-or-nothing” basis), the measurement step requires that each potential outcome be assigned a probability to determine the greatest amount of tax benefit whose probability of being realized is greater than 50 percent.

The outcome that provides the greatest tax benefit should be assessed first. If that outcome’s individual probability is greater than 50 percent, the individual probabilities of the remaining less beneficial outcomes need not be considered. The measurement step is concluded because the greatest amount of benefit was obtained from the most favorable outcome. Alternatively, if the individual probability of the greatest tax benefit is less than 50 percent, the next most beneficial outcome should be assessed. If that outcome’s individual probability coupled with the individual probability of the greatest tax benefit is greater than 50 percent, the second most beneficial outcome should be selected for measurement. If the cumulative probability of the second most beneficial outcome is not greater than 50 percent, the entity should continue the process until the probability of the selected outcome (added to the more beneficial outcomes previously assessed) is greater than 50 percent on a cumulative basis.

The concept of cumulative probability is best understood through an example that is similar to the example provided in ASC 740-10-55-102 through 55-104. Assume that a tax return includes a position that results in an as-filed benefit of $100. The position is considered to be more-likely-than-not sustainable based on its technical merits and thus meets the requirement for recognition.


In this case, $75 is the amount of tax benefit that would be recognized in the financial statements because it represents the largest amount of benefit that is more than
50 percent likely to be sustained upon settlement, based on the outcome’s cumulative probability.

16.4.1.1 Calculation of Individual Probability and Possible Outcomes

There is no prescribed method for determining the individual probability of each possible outcome. By necessity, such assessments will require management to exercise judgment. Probabilities can be based on factors such as (1) the perceived weight of the tax law in the taxpayer’s favor, (2) the extent of precedent of the tax law being applied to the particular position or transaction, (3) expectations regarding how aggressively the taxing authority might pursue a particular position or, alternatively, its willingness to reach a negotiated compromise, and (4) the entity’s willingness to defend the position in tax court (as opposed to conceding to a negotiated compromise to avoid the hazards of litigation). In the latter case, comparable and resolved exposures that the entity or similar entities have experienced will often be relevant to the development of measurement estimates and the assignment of individual probabilities. In this regard, it is expected that a history of negotiating and settling the same or similar tax positions would provide strong evidence in support of individual probabilities.

Furthermore, while all potential outcomes should be considered to determine possible measurement outcomes and their individual probabilities (e.g., litigation, negotiated compromise, etc.), detection risk cannot be considered. That is, measurement must be performed under the assumption that the taxing authority has full knowledge of the uncertain tax position.

16.4.1.2 Consideration of Past Audit Experience

A taxpayer’s past audit results can be considered in measuring the most likely amount of tax benefit that can be recorded for an uncertain tax position. If past audit results are the consequences of negotiation and settlement between a taxpayer and a taxing authority, for measurement purposes, the recent settlement of the same or similar position can be considered a reliable indication of the expected tax benefit that will be sustained on an audit of the same or a similar tax position, as long as no new information has arisen to suggest that the previously negotiated outcome would no longer be acceptable (ASC 740-10-55-109). That said, a taxpayer’s history of negotiating and settling with a taxing authority on the same or similar tax positions is only one source from which expected outcomes may be derived.

A taxpayer’s unique experience and resolution of a tax position with a taxing authority generally cannot be viewed as an acceptable administrative practice and precedent for the purposes of meeting the recognition threshold in ASC 740-10-25-6, unless the treatment is “widely understood” by other taxpayers (e.g., taxpayers in the same industry). Using past negotiations and settlements with a taxing authority as a “widely understood” practice for recognition purposes should not be confused with relying on past experience with the taxing authority, which remains a viable source from which possible outcomes may be derived for measurement (i.e., assuming that a particular position satisfies the recognition threshold).

Furthermore, a taxpayer’s lack of or limited audit history should not be taken into account when determining the expected outcome for measurement of a recognized tax benefit. As discussed previously, ASC 740-10-25-7 prohibits consideration of detection or tax examination risks. Therefore, when determining expected outcomes, a taxpayer must assume that the taxing authority has full knowledge of the uncertainty, even if a taxpayer has limited (or no) audit history demonstrating that a taxing authority will ultimately examine uncertain positions taken by the taxpayer. When a taxpayer has limited or no audit experience, other taxpayers’ experience with negotiating and settling the same or similar positions can be used as a source of expected outcomes. Relevant law (e.g., statute, regulations, rulings, case laws, etc.) that provides an indication as to the expected amount of tax benefit that may be sustained can also be used as a source of expected outcomes.

16.4.1.3 Use and Documentation of Cumulative Probability Table

Although ASC 740-10-30-7 requires the consideration of a range of possible outcomes, as well as their individual and cumulative probabilities (when appropriate), it does not mandate the use of cumulative probability tables (i.e., using a format that is the same or similar to the format included in ASC 740-10-55-103 and reproduced in Section TX 16.4.1 of this chapter). As explained below, some tax positions that meet the requirement for recognition may have one expected outcome that is clearly more than 50 percent likely to be sustained if challenged by the relevant taxing authority. A cumulative probability table for measuring such positions would not be needed to determine the greatest amount of tax benefit that can be recorded.

A circumstance that may not require a cumulative probability table, for example, is measurement of a tax position after settlement of a similar position. This is illustrated in ASC 740-10-55-109:

In applying the recognition criterion of this Subtopic for tax positions, an entity has determined that a tax position resulting in a benefit of $100 qualifies for recognition and should be measured. In a recent settlement with the taxing authority, the entity has agreed to the treatment for that position for current and future years. There are no recently issued relevant sources of tax law that would affect the entity’s assessment. The entity has not changed any assumptions or computations, and the current tax position is consistent with the position that was recently settled. In this case, the entity would have a very high confidence level about the amount that will be ultimately realized and little information about other possible outcomes. Management will not need to evaluate other possible outcomes because it can be confident of the largest amount of benefit that is greater than 50 percent likely of being realized upon settlement without that evaluation.


However, if various outcomes are reasonably possible and if the tax-benefit amount that straddles the more-likely-than-not cumulative probability is not readily apparent, it might be appropriate to develop a cumulative probability table.


16.4.1.4 Highly Certain Tax Positions

The tax treatment of certain tax positions is based on clear and unambiguous tax law. For these positions, the amount of benefit that is expected to be sustained is near certain. ASC 740-10-55-99 refers to these positions as highly certain tax positions. The measurement of highly certain tax positions in the financial statements represents the amount of benefit either expected to be claimed or actually claimed in the tax return. The following example is taken from ASC 740-10-55 and illustrates the measurement of a highly certain tax position.

Exhibit 16-5: Measurement of Highly Certain Tax Positions

ASC 740-10-55-100 through 55-101

An entity has taken a tax position that it believes is based on clear and unambiguous tax law for the payment of salaries and benefits to employees. The class of salaries being evaluated in this tax position is not subject to any limitations on deductibility (for example, executive salaries are not included), and none of the expenditures are required to be capitalized (for example, the expenditures do not pertain to the production of inventories); all amounts accrued at year-end were paid within the statutorily required time frame subsequent to the reporting date. Management concludes that the salaries are fully deductible.

All tax positions are subject to the requirements of this Subtopic. However, because the deduction is based on clear and unambiguous tax law, management has a high confidence level in the technical merits of this position. Accordingly, the tax position clearly meets the recognition criterion and should be evaluated for measurement. In determining the amount to measure, management is highly confident that the full amount of the deduction will be allowed and it is clear that it is greater than 50 percent likely that the full amount of the tax position will be ultimately realized. Accordingly, the entity would recognize the full amount of the tax position in the financial statements.

16.4.1.5 Binary Tax Positions

A taxing authority may not always be willing (or in certain cases legally permitted) to accept a compromise on a position. Additionally, there may be positions taken by an entity that are so significant (e.g., status of the entity) that the entity cannot negotiate with the taxing authority. This subset of uncertain tax positions are considered binary. This means there are two possible outcomes:

1. If the position is sustained, the entire as-filed tax return amount (i.e., 100 percent of the benefit) will be accepted.

2. If the position is lost upon challenge, none of the as-filed tax return amount (i.e., zero benefit) will be accepted.

That is, the expected tax benefit of an uncertain tax position that has a binary outcome is either sustained or denied in its entirety. When a binary tax position qualifies for recognition, the measurement of the largest amount of tax benefit would generally cause 100 percent of the expected benefit (i.e., the as-filed amount) to be recorded.

16.4.2 Measurement and Transfer Pricing

Certain situations, such as transfer pricing, might produce a number of different outcomes. Absent a reasonable number of comparable and resolved exposures that the entity or similar entities have experienced, there might not be sufficient information to develop a probability assessment of every possible outcome. Yet, the entity must develop and support a conclusion as to which possible outcome represents the one that provides for the greatest benefit that has a greater than 50 percent cumulative probability of being sustained. The assignment of probabilities to a particular outcome is not an exact science. This exercise depends heavily on the facts and circumstances that are specific to the particular transaction in question, management’s experience and knowledge of the tax authority’s position on particular transactions, and the experience and knowledge of industry peers with respect to settlements and strategies. Consideration should be given to the requirement to defer tax consequences in accordance with ASC 740-10-25-3(e) when an uncertain tax position relates to an intra-entity transfer of assets (see Section TX 16.5.6.1).

As mentioned in Section TX 16.3.1.2, entities measuring the amount of an uncertain tax position should evaluate any offsetting transaction separately on a gross basis, and record the corresponding tax payable (or receivable) on a gross basis on the balance sheet. Uncertain tax positions related to transfer pricing are no exception. Specifically, unrecognized tax benefits from one jurisdiction may not be netted against a deferred tax asset or potential tax overpayment receivable from another jurisdiction. Interest calculations for the respective tax liabilities and assets should also be performed on a separate jurisdictional basis.


16.4.2.1 Contemporaneous Documentation

The existence of contemporaneous documentation, which covers an entity’s intercompany transactions, is not sufficient to conclude that there are no uncertain tax positions associated with intercompany transactions. Contemporaneous documentation typically helps determine whether an entity appears to have met the standards of reasonableness with respect to transfer pricing penalties as set forth in IRC Regulation §1.6662-6, but does not determine the likelihood that a position will be sustained, whether a particular position has a greater than 50 percent cumulative probability of being sustained, or whether there are particular alternative outcomes that might be asserted by the respective taxing authorities.

Accordingly, entities may need to consider alternative transfer pricing methods or profit-level indicators in their analysis of alternative settlement positions. The best method for transfer pricing documentation is not necessarily the only method that should be considered. The best method analysis contained in transfer pricing documentation may describe only why an entity did not choose other methods (and should be protected from penalty exposure). Entities may need to review other methods and their respective results more closely.

16.4.3 Interrelationship of Measurement and Recognition

Generally, the individual and cumulative probabilities that are considered relevant to the measurement step would not have a direct impact on the recognition step. Once a tax position has satisfied the more-likely-than-not requirement for recognition, the position should be evaluated to determine the measurement of the largest amount of tax benefit that can be recorded in the financial statements. However, when the tax benefit amount that is recorded under the measurement step is insignificant in relation to the total position taken or expected to be taken on a tax return, the more-likely-than-not conclusion reached in the recognition step may need to be reevaluated.

16.4.4 The Implications of “Should” Level Tax Opinions

The recognition and measurement of a tax position are two separate steps in the ASC 740 accounting model. A tax opinion issued by outside counsel or another tax service provider can constitute external evidence supporting management’s assertions in relation to the recognition of a tax position. A tax opinion (with no significant caveats) that concludes that a tax position should be sustained may indicate that the recognition threshold has been met, but may not be sufficient to justify recording 100 percent of the expected tax benefit, especially if the opinion addresses the sustainability of the position without identifying the amount that can be sustained. Furthermore, if an entity knows or has reason to believe that the relevant taxing authority expects some concession and the entity does not intend to litigate, it would suggest that less than 100 percent of the expected tax benefit might be the largest amount of benefit that has a cumulative probability greater than 50 percent, notwithstanding the existence of a should level opinion.

16.5 Changes in Recognition and Measurement in Subsequent Periods




The assessment of an uncertain tax position is a continuous process, which does not end with the initial determination of a position’s sustainability. As of each balance sheet date, unresolved uncertain positions must be reassessed. Management must determine whether the factors underlying the sustainability assertion have changed and whether the amount of the recognized tax benefit is still appropriate.

ASC 740-10-25-14 specifically states that an uncertain tax position does not need to be legally extinguished nor does its resolution need to be certain to be recognized, derecognized or measured. Furthermore, ASC 740-10-25-14 requires that changes in the expected outcome of an uncertain tax position be based on new information, and not on a mere reevaluation of existing information. New information can relate to developments in case law, changes in tax law, new regulations issued by taxing authorities, interactions with the taxing authorities, or some other development. Such developments could potentially change the estimate of the amount that is expected to eventually be sustained or to cause a position to cross over the recognition threshold (i.e., either the position’s sustainability becomes more-likely-than-not or the position ceases to meet the recognition threshold).

New information would exist if management’s previous evaluation was fully informed and based on all relevant facts and if, in the intervening period, legislative developments or developments in case law gave rise to the different interpretation of outside counsel. New information requires a new judgment on whether the recognition threshold has been met.

The following example illustrates a fact pattern whereby an entity is evaluating whether a proposed settlement with the taxing authority provides new information.

Example 16-7: Consideration of a Tentative “Global” Settlement with a Taxing Authority in Measuring Uncertain Tax Positions

Background/Facts:

Company A has multiple uncertain tax positions, all of which have been assessed under ASC 740. Some tax positions met the recognition threshold of ASC 740, while other positions did not. The individual tax positions are not similar, nor interdependent. Positions that did not meet the recognition threshold were fully reserved (i.e., no benefit has been recognized). The taxing authority is conducting an audit of three years in which the positions were taken.

The Company has been in negotiations with the taxing authority and, as of the end of the current reporting period, the parties have reached a tentative “global” settlement agreement. The agreement would settle all positions within the three tax years under examination, and close out the audit for those years. While the Company believes they have reached an agreement with the taxing authority’s examination team, the agreement is subject to another level of governmental review before it becomes final and binding.

Company A determined that the additional level of review is substantive, and could result in the agreement being changed or withdrawn (by either party). As a result, the Company determined that the uncertain tax positions that have not met the recognition threshold are not considered “effectively settled” as described in ASC 740-10-25-10. In addition, no new information came to light during the examination process that would cause Company A to change its assessment of the technical merits of any of the individual uncertain tax positions. Therefore, no adjustment will be made to the tax positions that have not met the recognition threshold.

Question:

For positions that have met the recognition threshold, should Company A adjust its measurement of the related benefit of those positions based upon the tentative global settlement agreement?

Analysis/Conclusion:

It depends. Company A must determine whether the proposed global settlement changes their assessment of the expected outcome for each tax position that has met the recognition threshold. In making this determination, the Company should consider its expected course of action, and related expected outcome, if the global settlement proposal is withdrawn or changed in the review process.

While ASC 740-10-25-14 requires companies to continually remeasure tax positions “based on management’s best judgment given the facts, circumstances, and information available at the reporting date,” subsequent changes must be based on “new information.”

In this case, Company A determined that the global settlement proposal was merely a part of the on-going examination and negotiation procedures and that it did not constitute “new information” that changed their assessment of the outcome of any individual tax position. Negotiations with the taxing authority appear to have been conducted on a global basis which aggregated all positions, rather than on an individual position-by-position basis. Consequently, the Company concluded there was no new information with respect to any of the individual tax positions that caused management to change their previous assessment (i.e., no adjustment to the measurement of the related benefit is necessary).

16.5.1 Considering the Impact of a Jurisdiction’s Dispute-Resolution Process

In addition to monitoring developments in the technical merits of a position, entities must monitor the progress of the dispute-resolution process to determine whether a tax position is effectively settled through examination, negotiation, or litigation.

There may be phases in the taxing authority’s examination process that provide new information, which would result in recognition or remeasurement of a tax position or, in some cases, de-recognition of a previously recognized tax position. Entities must also consider this key question: Is recognition of tax benefits or remeasurement of previously recognized tax benefits appropriate when a tax examination is closed, even if the relevant statute of limitation for assessing taxes is still open? This determination is critical because, in many cases, a taxing authority completes its examination of a tax year before the statute of limitations expires.

16.5.2 Effective Settlement of a Tax Position

In analyzing whether a tax position meets the three conditions of ASC 740-10-25-10 (as referenced above) and can therefore be considered effectively settled, the following key considerations should be noted:

A tax position not specifically examined: As stated in ASC 740-10-25-11, a tax position does not need to be specifically reviewed or examined by the taxing authority during the examination of a tax year in order for it to be considered effectively settled through examination.


Completion of examination and other procedures: When evaluating the requirement of ASC 740-10-25-10(a), a unique challenge may arise with respect to NOL and tax credit carryforwards. To illustrate, assume that a U.S. entity generated an NOL carryforward of $500 on its tax return for a particular year, but only $400 of that amount was recognizable in the financial statements because of an uncertain tax position that totaled $100. The uncertain position is not examined by the IRS in the subsequent examination, and the examination is later closed. In this case, it is unlikely that the entity would be in a position to conclude that the unrecognized benefit of $100 was effectively settled upon closure of the examination for the year in which the NOL first arose. This is because the IRS not only has the ability to examine or reexamine the positions that led to the generation of NOL and tax credit carryforwards, but in many cases will examine or reexamine those positions when assessing whether a benefit from the utilization of those items should be allowed on a future year’s tax return. The IRS can perform the reexamination even if the year in which the items were generated was already subjected to examination and the statute of limitations for the year of generation has since expired. Other jurisdictions may have the same or a similar ability based in tax law, regulations, or judicial doctrine.

Remote likelihood of reexamination: Evaluating whether the requirement of ASC 740-10-25-10(c) has been met is likely to involve the most difficult judgments. This is due in part to the differing practices of taxing authorities and to the lack of experience that entities may have in evaluating these practices. Entities may find it particularly difficult to evaluate whether it is remote that the taxing authority would examine or reexamine the position (assuming that the taxing authority has full knowledge of all relevant information).


ASC 740-10-40-3 requires the continuous reevaluation of tax positions that were already determined to be “effectively settled.” An entity should reevaluate a tax position that was “effectively settled” if the entity believes that a taxing authority may examine or reexamine a tax position, or if the entity intends to appeal or litigate any aspect of the tax position. Under these circumstances, the tax position would no longer be considered “effectively settled.”

ASC 740-10-25-12 acknowledges that an entity may obtain information during an examination that would enable it to change its assessment of the technical merits of a tax position or of similar tax positions taken in other periods. However, the fact that a position has been effectively settled for a given year should not be used as a basis for concluding that similar tax positions taken in future years can be recognized. For example, consider an entity that took a tax position for which a tax benefit was not recognized because it did not meet the ASC 740-10-25 recognition criteria. The fact that this position was effectively settled for a particular year does not constitute new information that would allow the entity to recognize the benefit from similar positions taken in subsequent years.

In many jurisdictions, the resolution process for a challenged tax position can potentially involve several stages and various government departments, each of which might be empowered to overturn or modify another department’s ruling. The appropriate stage in the resolution process that provides sufficient evidence for recognition of the reserved tax benefit is reached when an entity concludes that a tax position is “effectively settled.”

Under the U.S. federal income tax system, Form 870, Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment, is used upon completion of an IRS examination to indicate the taxpayer’s agreement with the revenue agent’s proposed adjustments and agreement to pay the deficiency. The Revenue Agent’s Report accompanies the Form 870. By signing the Form 870, the taxpayer waives the right to a notice of deficiency and thus permits the IRS to assess the tax immediately. In effect, this represents the closing of the IRS examination upon acceptance by the IRS. Generally, the IRS will only reopen a closed case if (1) there is evidence of fraud, malfeasance, collusion, concealment, or misrepresentation of a material fact, (2) the closed case involves a clearly defined, substantial error based on an established service position existing at the time of the examination, or (3) other circumstances exist which indicate that a failure to reopen the case would be a serious administrative omission.

We would generally expect the closing of an IRS examination to constitute effective settlement of a position taken in the examined year(s) when not being appealed, other than cases involving continued governmental review (e.g., Joint Committee) or years in which there was no tax payable (e.g., NOL years). PwC engagement teams are encouraged to consult with the Accounting Services Group within PwC’s National Professional Services Group if it is concluded that effective settlement has not occurred other than in circumstances as described above.

The following discussions are based on our understanding of the U.S. federal income tax system. However, they can also be applied in concept to other taxing authorities.

Example 16-8: Impact of Closing an Appeal on Recognition

The effectively settled guidelines may also affect the determination as to whether the recognition threshold is met for a tax position after an appeal. For example, an uncertain tax position that does not initially meet the recognition threshold is not measured, and a full liability for the expected benefit is recorded. The audit is closed and the tax position is examined by the IRS appeals division, which issues a Form 870-AD, Offer to Waive Restrictions on Assessment and Collection of Tax Deficiency and to Accept Overassessment, related specifically to the position. Form 870-AD is used almost exclusively by Appeals and differs from Form 870. Specifically, Form 870-AD states that the case will not be reopened by the IRS unless, among other things, there was “fraud, malfeasance, concealment or misrepresentation of a material fact,” “an important mistake in mathematical calculation,” or “excessive tentative allowance of a carryback.”

We would generally expect the closing of an audit through a Form 870-AD would constitute effective settlement by having met the three conditions outlined in ASC 740-10-25-10.

In addition, an IRS review at the appeals level could provide new information to support initial recognition under ASC 740-10-25-10. The nature and extent of the IRS examination process at the appeals level may validate or strengthen the merits of the position. Accordingly, new information resulting from an appeals-level review could lead to the conclusion that the position is more-likely-than-not to be sustained based on its technical merits.


As illustrated in the following example, the unit-of-account for purposes of analyzing the requirements for effective settlement is a tax position and not the tax return period under audit.

Example 16-9: Determining when a Tax Position is “Effectively Settled”
with the IRS

Background/Facts:

Company A has three uncertain tax positions (UTPs) in its 20X7 federal tax return; none of which met the more-likely-than-not recognition threshold under ASC 740-10-25-6. The individual tax positions are neither similar nor interdependent.

During 20X9, the IRS audited the 20X7 tax return. After specifically examining UTP1, in Q3 20X9 the examining agent informed Company A that there would be no adjustment to UTP1. The examination of UTP1 did not, however, yield any information that changed Company A’s view that the position failed the recognition threshold based upon its technical merits. UTP2 was not specifically examined. The audit was concluded in Q4 with the issuance of the Revenue Agent’s Report (RAR) and Form 870 which disallowed only UTP3. Company A intends to appeal the disallowance of UTP3. The status of the UTPs is summarized as follows:


Question:

When can Company A assert “effective settlement” of UTP1 and UTP2?

Analysis/Conclusion:

Effective settlement of a tax position is dependent upon whether the facts and circumstances satisfy the three requirements in ASC 740-10-25-10.

UTP1:

To satisfy the first requirement, Company A should consider the respective taxing authority’s policies and procedures for completing an examination.5 The policy of the IRS indicates that an examination is closed when the examining agent presents written notification of either (1) adjustments to the company’s tax liability or
(2) acceptance of the company’s tax return without change. Although the examining agent verbally indicated acceptance of UTP1 in Q3, the examination was not concluded until the RAR and Form 870 was issued in Q4. Since Company A does not intend to appeal or litigate any aspect of UTP1, the second requirement is satisfied.

5 Policies, procedures and historical practices of taxing authorities should be considered at the relevant jurisdictional level (i.e., U.S. federal, U.S. state and local, foreign, etc.) in determining whether a position is effectively settled.

In evaluating whether the third requirement has been met, Company A should consider the IRS policy and historical practices with respect to the appeals process. Specifically, Company A must assess whether there is a more than remote likelihood of the IRS reexamining UTP1 during the appeal of UTP3. The IRS policy for the appeals process is to resolve specific issues in dispute rather than extend the examination, absent unusual circumstances. The policy limits the circumstances in which a “new issue” may be introduced by the IRS during the appeals process. The policy defines a new issue effectively as an issue not being appealed, and applies regardless of whether the issue was specifically examined. In effect, the appeals process policy is aligned with the IRS audit policy which provides that an audit will be reopened only in narrowly defined circumstances.6

6 Refer to Section TX 16.5.2.

Unless Company A’s facts suggest circumstances which would support reopening an exam, in accordance with IRS policies, UTP1 would be effectively settled in Q4 20X9.

UTP2:

Similar to UTP1, the first and second requirements are satisfied with respect to UTP2 upon the issuance of the RAR in Q4. ASC 740-10-25-11 states that a tax position does not need to be specifically examined in order for it to be considered effectively settled. Thus, UTP2 could potentially be effectively settled in Q4 unless the likelihood of the IRS examining UTP2 during the appeal of UTP3 is more than remote. Similar to the above analysis of UTP1, UTP2 would also likely be considered effectively settled in Q4 20X9.

Example 16-10: Tax Audit under a “LIFE Exam” Program

In the U.S. federal tax jurisdiction, certain entities may agree to participate in IRS tax audit programs that provide for exam scope pre-determination. In IRS audits, such programs are termed “Limited Issue Focused Exams” (LIFE exams). Although an uncertain tax position may initially meet the recognition threshold, the measurement process may result in less than the full benefit being recorded in the financial statements. Additionally, the position may not be included in the documented pre-determined scope.

Based on discussions with the FASB staff, if the recognition threshold is initially met, but only a partial benefit is recorded in the financial statements, the status of a tax examination should be considered in the reevaluation of the benefit measured. If the taxing authority provides an indication that the tax position will not be examined and that the examination will be limited to pre-agreed issues, then such an indication may be viewed as new information in support of a reevaluation of the measured benefit.

However, for the purposes of remeasuring the tax position, the entity must consider the status of the examination, as well as the likelihood that the taxing authority would challenge the position (assuming the taxing authority has all of the relevant information). That is, a company would remeasure the tax position if it is unlikely that the tax position would be challenged, even if the taxing authority were presented with all of the relevant information. It should be noted that the IRS is able to alter the LIFE exam scope because such an exam is considered a memorandum of understanding, not a legally binding agreement.

16.5.3 Other Considerations in the Tax Examination Process

16.5.3.1 Amended Return/Tax Receivable

Section TX 16.3.2.10 discusses the application of ASC 740’s recognition and measurement criteria to refund claims. Generally, filing an amended return results in a tax receivable. When the filed, or expected to be filed, amended return includes an uncertain tax position, the recognition, derecognition, and remeasurement of the receivable should apply ASC 740’s recognition and measurement criteria. We believe that the threshold for the recognition of the associated tax benefit should be the same, regardless of whether the accounting entry results in a tax receivable, a decrease in a liability for an unrecognized tax benefit, or a current tax payable. However, obtaining the tax benefit might involve additional procedural steps (e.g., in the U.S. federal tax jurisdiction, approval by additional government authorities, such as the Joint Committee on Taxation that serves under the U.S. Congress), which might affect the risk that an advantageous lower-level decision could be reversed.

16.5.3.2 Competent Authority

Competent Authority (“CA”) resolution is a formal agreement between the taxing authorities of two countries interpreting provisions in a bilateral income tax treaty for the elimination of double taxation. A resolution by a CA is applicable to entity-specific facts and circumstances. Section TX 16.3.2.2 specifies that a CA resolution can be considered authoritative tax materials used in recognition. A CA resolution is handled by designated representatives of both countries who are charged with the task of clarifying and interpreting the provisions of international income tax treaties for the elimination of double taxation. Entities can invoke the CA process when they believe that the actions of the taxing authorities cause a tax situation that was not intended by a treaty between two countries (e.g., double taxation), or when they need specific treaty provisions to be clarified or interpreted. The fact that the CA has agreed with an entity’s position would presumably provide sufficient evidence to meet the recognition threshold. However, this might still be subject to further approvals in certain tax jurisdictions (e.g., the approval of the Joint Committee on Taxation for U.S. federal tax refunds over a defined amount).

16.5.3.3 Relevance of Resolution Experience to Future Periods

The resolution of an uncertain position in a given audit cycle should also be assessed for its relevance to future periods. For example, the resolution of an uncertain tax position in a given audit cycle might involve the new or additional interpretation (or clarification) by the taxing authority of the relevant authoritative tax materials and their applicability to the uncertain tax position. This new or additional information might provide evidence supporting the technical merits of a similar position in subsequent periods and therefore may allow recognition of a similar position pursuant to ASC 740-10-25-8(a). However, the resolution of an uncertain position in a given audit cycle may arise from an uncertain tax position that satisfies the three conditions that must be met to be considered effectively settled pursuant to ASC 740-10-25-10. In such circumstance, management’s assessment that the effectively settled conditions with respect to an uncertain tax position have been met in a given audit cycle does not provide any basis on which management may change its assessment of the technical merits of the same or a similar position taken in other periods (ASC 740-10-25-12). That is because the taxing authority may not examine the uncertain tax position in a given audit cycle (and thus may not provide any technical insight), even though the effectively settled conditions have been met in that audit cycle.

Additionally, the resolution might not provide any technical insight if it is the result of a negotiated settlement that involves many issues and so-called “horse-trading” without respect to the technical merits of the resolved position. Management will have to consider the factors that could change the taxing authority’s stance in subsequent periods (e.g., the level at which a resolution was reached, the substance of communication and argumentation during the resolution process, and the materiality and importance of the position relative to the tax return).

16.5.3.4 Entities Not Subject to Audit by a Taxing Authority

Although the Board clarified that finality of outcome is not required to recognize a benefit, the Board made its rejection of any consideration of detection risk equally clear. Hence, an entity that is not subject to the taxing authority’s audit and subsequent resolution process will have to delay recognizing a tax benefit that did not meet the recognition and measurement criteria of ASC 740 until the statute of limitations runs its course or until subsequent changes in the technical merits of the tax position permit a change in judgment about the position’s sustainability.

16.5.4 Subsequent Derecognition

ASC 740-10-40-2, states that a previously recognized tax position should be derecognized in the first period in which the position no longer meets the more-likely-than-not recognition threshold. New information resulting in derecognition must be considered and accounted for even if that derecognition results in a deferred tax asset that would require a valuation allowance to be recorded against it. As noted in ASC 740-10-40-2, the “use of a valuation allowance is not a permitted substitute for derecognizing the benefit of a tax position when the more-likely-than-not recognition threshold is no longer met.”

16.5.5 Subsequent Events

Relevant developments occurring after the balance sheet date but before issuance of financial statements (which would include the discovery of information that was not available as of the balance sheet date) should be considered a nonrecognized subsequent event for which no effect would be recorded in the current-period financial statements. Only an explanatory disclosure of the event (if it is significant) is required.

Exhibit 16-6: New Information Received After the Reporting Date

ASC 740-10-55-118 through 55-119

Entity A has evaluated a tax position at its most recent reporting date and has concluded that the position meets the more-likely-than-not recognition threshold. In evaluating the tax position for recognition, Entity A considered all relevant sources of tax law, including a court case in which the taxing authority has fully disallowed a similar tax position with an unrelated entity (Entity B). The taxing authority and Entity B are aggressively litigating the matter. Although Entity A was aware of that court case at the recent reporting date, management determined that the more-likely-than-not recognition threshold had been met. Subsequent to the reporting date, but prior to the issuance of the financial statements, the taxing authority prevailed in its litigation with Entity B, and Entity A concludes that it is no longer more-likely-than-not that it will sustain the position.

Paragraph 740-10-40-2 provides the guidance that an entity shall derecognize a previously recognized tax position in the first period in which it is no longer more-likely-than-not that the tax position would be sustained upon examination, and paragraphs 740-10-25-14; 740-10-35-2; and 740-10-40-2 establish that subsequent recognition, derecognition, and measurement shall be based on management’s best judgment given the facts, circumstances, and information available at the reporting date. Because the resolution of Entity B’s litigation with the taxing authority is the information that caused Entity A to change its judgment about the sustainability of the position and that information was not available at the reporting date, the change in judgment would be recognized in the first quarter of the current fiscal year.


16.5.6 Recording the Effects of Changes in Recognition and Measurement During the Year


When new information causes a change in judgment about recognition, derecognition, or a change in measurement of an uncertain tax position (including any related interest and penalty) that was taken in a prior year, the effect should be recorded discretely in the period in which the change in judgment occurs (ASC 740-10-25-15). Changes in judgment related to uncertain tax positions taken in a prior interim period but within the same current fiscal year are an integral part of an annual period, and should be accounted for in accordance with the principles of ASC 740-270-35. Section TX 17.1.1.4.1 includes a discussion about which tax effects are included as part of the consolidated annual effective tax rate and which ones are recorded based on year-to-date activity.

16.5.6.1 Interaction with Intra-entity Transactions (ASC 740-10-25-3(e))

Certain aspects of an intra-entity transaction, such as transfer pricing, might result in uncertain tax positions taken by a company. Such uncertain tax positions should be recognized and measured in accordance with the guidance in ASC 740 similar to all other uncertain tax positions. However, as further discussed in Section TX 2.3.4, no immediate tax impact should be recognized in a company’s consolidated financial statements as a result of an intra-entity transfer of assets. As illustrated in the example below, this exception is also applicable to subsequent changes in the recognition and measurement of unrecognized tax benefits resulting from such transactions.

Example 16-11: Considering the Effects of Changes in Measurement of Uncertain Tax Positions When Accounting for Intra-entity Transactions Under ASC 740-10-25-3(e)

Background/Facts:

Company A is a multinational corporation that developed intellectual property (IP) in the U.S. In the previous year, the U.S. parent entered into an arrangement to transfer the IP to its foreign subsidiary in exchange for a lump sum payment. At the time that the arrangement was executed, the Company determined that there was no uncertainty in the tax position and therefore no liability for an unrecognized benefit was recorded. The Company accounted for the IP transfer as a sale of an asset and therefore deferred the taxes paid on its transfer under ASC 740-10-25-3(e). This deferred charge is being amortized over the economic life of the IP.

During a subsequent reporting period in which the deferred charge continues to be amortized, the IRS performs an audit of the IP transfer and challenges the valuation of the IP. As a result, the IRS contends that the taxes paid by Company A should have been greater.

Question:

Assuming a liability must be recorded as a result of new information arising from the IRS audit, should the amount of the unrecognized tax benefit be deferred pursuant to ASC 740-10-25-3(e)?

Analysis/Conclusion:

Yes. Pursuant to ASC 740-10-25-3(e) no immediate tax impact should be recognized in the financial statements as a result of intra-entity transfers of assets. This includes all taxes incurred by the seller including any unrecognized tax benefit associated with the transaction.

Similar to the tax the Company originally calculated on the transfer, the incremental tax effect of the uncertain tax position should also be deferred and amortized over the economic life of the IP. We believe that one acceptable approach would be to account for the additional tax charge through a cumulative catch-up adjustment. That is, the Company would adjust the remaining balance of the deferred charge to the amount that would have been recorded had the benefit been unrecognized the IP was originally transferred.

16.6 Interest and Penalties

Generally, taxing authorities assess interest on any underpayment of tax, but only assess penalties if a disallowed position fails to meet certain minimum thresholds of support.

16.6.1 Interest


As noted above, the Board believes that if a benefit claimed on a tax return does not qualify for financial reporting recognition, the benefit essentially constitutes a loan from the government and therefore results in an interest charge. Consequently, the Board concluded that the basis for an interest accrual should be the difference between the tax position recognized in the financial statements and the amount claimed (or expected to be claimed) in the tax return. The commencement of an interest accrual should be in accordance with the relevant tax law. For example, in the U.S. federal tax system, a calendar-year corporation generally starts accruing interest two and one-half months after the end of the tax year for which the position was taken on a tax return. Interest should be accrued each period prior to ultimate resolution of the uncertainty.

16.6.1.1 Interest Income on Uncertain Tax Positions

While ASC 740 does not reference interest income specifically, we believe that interest income related to uncertain tax positions should be accounted for in the same manner as interest expense. That is, interest income should be recognized over the time period in which it accrues under the applicable tax law.

Example 16-12: Recording Interest Income on a Transfer Pricing Tax Position

Background/Facts:

Assume that Company XYZ has taken a position related to transfer pricing. In Jurisdiction A, Company XYZ has recorded a liability for an unrecognized tax benefit for $100, and will record interest expense under ASC 740-10-25-56 at a rate of 5 percent per year. However, under competent authority between Jurisdiction A and Jurisdiction B, Company XYZ believes that it is more-likely-than-not that it will be able to amend its tax return for Jurisdiction B to reduce its taxable income for the related tax position that was not sustained in Jurisdiction A. In addition, Company XYZ would be entitled to interest income on the overpayment of tax for the amended return in Jurisdiction B at a statutory interest rate of 6 percent.

Analysis/Conclusion:

We believe that Company XYZ should record interest expense on the liability of $5 ($100 x 5%) in Jurisdiction A and also record interest income of $6 ($100 x 6%) in Jurisdiction B.

Example 16-13: Recording Interest Income on Overpayments of Tax

Background/Facts:

In applying the recognition criteria of ASC 740-10-25, Company A has determined that a tax position resulting in a $1,000 tax benefit qualifies for recognition and should be measured. After considering all relevant information, management believes that there is a greater than 50 percent chance that 100 percent of the benefit will be realized. To stop interest charges from accumulating in the event that it loses the issue, Company A makes a payment to the taxing authority for the $1,000. Under the laws of the jurisdiction in which this uncertainty exists, Company A will receive interest income from the taxing authority if the position is ultimately sustained.

Analysis/Conclusion:

Because $1,000 is the largest amount of benefit that is greater than 50 percent likely to be realized upon settlement, the $1,000 payment would be considered a pre-payment to the taxing authority and recorded as an asset. Given that the settlement of the amount recorded in the financial statements would entitle Company A to interest income on the $1,000 pre-payment, this interest income should be accrued by Company A.


Example 16-14: ASC 835-20 Capitalization of Interest Expense on the Underpayment of Income Taxes

Background/Facts:

Company A has taken an uncertain tax position that reduces taxes payable by $100. In assessing the uncertain tax position, Company A has determined that it is more-likely-than-not that the position, based on its technical merits, will be sustained upon examination. In performing the measurement step in ASC 740-10-30-7, Company A determined that $60 is the largest tax benefit that is greater than 50 percent likely to be realized upon settlement with the taxing authority. Therefore, Company A has recorded a $40 liability for the unrecognized tax benefit.

Company A has an ongoing significant capital project that was financed through the issuance of debt. A portion of this interest expense is being capitalized to the project under ASC 835-20. Company A is also required to accrue interest on the unrecognized tax benefit ($40 in this example) under the provisions of ASC 740-10-25-56. Further, in accordance with ASC 740-10-45-25, it has elected to classify the interest on the underpayment of income taxes as interest expense in the income statement.

Question:

Does ASC 835-20, require Company A to capitalize the interest expense on their liability for unrecognized tax benefit?

Analysis/Conclusion:

No. ASC 835-20-30-2 indicates that the amount of interest to be capitalized is the portion of interest cost that theoretically could have been avoided (by avoiding additional borrowings or paying down existing borrowings) if the expenditures for an asset had not been made. Interest costs arising from liabilities for unrecognized tax benefits are not borrowings contemplated by ASC 835-20. Rather, a liability for an unrecognized tax benefit is recognized for tax positions that do not meet the recognition and measurement criteria of ASC 740. In addition, the underlying liability is not treated as debt in other areas of the financial statements.

16.6.2 Penalties


In its deliberations, the Board considered whether penalties should be accrued in the period for which management expects to take a position that is below the applicable minimal statutory threshold to avoid penalties or, alternatively, whether penalties should be accrued in the period in which the entity files the tax return that reflects the position. Although only the filing actually creates a legal obligation, the Board concluded that it would be more appropriate to record a penalty in the period for which a tax position is expected to be taken.


Example 16-15: Considering a Taxing Authority’s Past Practices to Determine Whether a Tax Penalty Should Be Accrued

Background/Facts:

Company X has filed tax returns in Jurisdiction Y and has determined that after the application of ASC 740’s recognition and measurement criteria, $100 of a tax benefit claimed on its tax return in Jurisdiction Y cannot be recognized for financial reporting purposes.

The relevant tax law in Jurisdiction Y provides for a 50 percent penalty assessment on any unpaid balance that exists after the original due date of the tax return (this amount is in addition to the requirement for interest to be paid on the unpaid balance). It is widely known that in Jurisdiction Y, the taxing authority routinely charges interest for underpayments, but historically has only assessed the 50 percent penalty if fraud is suspected or if the expectation that the tax position will be sustained based upon its technical merits is remote.

Company X has concluded that the tax position at issue did not constitute fraud and that the position has more than a remote chance of being sustained based on its technical merits.

Question:

How should Company X account for the penalty under the relevant tax law in Jurisdiction Y? Specifically, can ASC 740 be interpreted to infer a penalty threshold in a particular jurisdiction as a matter of administrative practice or precedent if such a threshold does not statutorily exist?

Analysis/Conclusion:

In this instance, the taxing authority appears to have established a de facto minimum statutory threshold for assessment through its historical administrative practice of not assessing the 50 percent penalty unless fraud is present or there is only a remote chance that the position will be sustained based on its technical merits.

ASC 740-10-25-57 states, “If a tax position does not meet the minimum statutory threshold to avoid payment of penalties (considering the factors in paragraph 740-10-25-7), an entity shall recognize an expense for the amount of the statutory penalty in the period in which the entity claims or expects to claim the position in the tax return.”

Although it could be argued that the administrative practice accommodation as highlighted in ASC 740-10-25-7 should not be considered in deciding whether penalties should be accrued, it does not appear that the FASB contemplated situations where there is no stipulated minimum statutory threshold to avoid a penalty (e.g., certain jurisdictions outside the Unites States).

Consistent with ASC 740-10-25-7 which provides that “when the past administrative practices and precedents of the taxing authority in its dealings with the entity or similar entities are widely understood, for example, by preparers, tax practitioners and auditors, those practices and precedents shall be taken into account,” we believe that the existence of a widely understood administrative practice in regard to penalties should be considered when applying ASC 740-10-25. By virtue of its practice of applying penalties in only instances of fraud and circumstances where the expectation of the tax position being sustained upon challenge is remote, the taxing authority has created a de facto minimum threshold for assessing penalties. Company X should consider this administrative practice when determining whether a position fails to meet an implied threshold to avoid a payment of penalties in Jurisdiction Y. Thus, under the fact pattern presented above, the 50 percent penalty should not be accrued because it is widely understood that Jurisdiction Y’s taxing authority will not assess the 50 percent penalty.

16.6.3 Accounting Policy Election for Classification of Interest and Penalties


ASC 740-10-45-25 gives entities the option, by means of an accounting policy election, to classify interest and penalties as components of either income tax expense or as part of pretax income, depending on the entity’s accounting policy. As a result, any change in classification for either interest or penalties would be treated as a change in accounting principle subject to the requirements of ASC 250, Accounting Changes and Error Corrections. If upon adoption of ASC 740’s guidance related to uncertain tax positions, an entity adopts a new financial statement classification of interest and penalties, it should disclose that it has adopted a new accounting principle and disclose its new policy for classification of interest and penalties. Because the FIN 48 transition provision precludes any form of retroactive application, financial statements for periods presented prior to adoption of FIN 48 should not be retroactively restated or reclassified to conform to the newly adopted accounting principle.

However, an entity should disclose its policy for the classification of interest and penalties for prior periods. If an entity has changed its classification policy, the entity should disclose (in its annual financial statements that include any period prior to adoption of the ASC 740 guidance related to uncertain tax positions) both the classification and amount of interest and penalties on uncertain income tax positions reflected in each income statement. If the entity cannot determine the amount of interest and penalties for periods prior to the adoption of the guidance due to its inability to disaggregate the interest or penalties portion of the accrual from the underlying tax exposure, it should disclose that fact.

At the AICPA conference, the SEC staff stated that they believe the accounting policy for interest and penalties should be applied consistently throughout the financial statements. That is, the policy should be applied consistently in the balance sheet, the income statement, the statement of cash flows, and any related disclosure requirements.

When the accounting policy election is to classify interest and penalties as “above the line” income statement items (i.e., included in pretax income or loss), the accrued balance sheet amounts should not be included with the balance sheet tax account (as either deferred tax liabilities or liabilities for unrecognized tax benefits), but should instead be included with accrued interest and other accrued expense (for penalties). Conversely, when the accounting policy is to classify interest and penalties as income tax expense, they should be included with the liabilities for unrecognized tax benefits. It should also be noted that classifying accrued interest and penalties as part of the liability for unrecognized tax benefits does not mean that the amount accrued should also be included in the annual tabular reconciliation disclosure because accrued interest and penalties are not considered unrecognized tax benefits.

16.7 Balance Sheet Classification



16.7.1 Background

ASC 740-10-45-11 indicates that the balance sheet classification of a liability for an unrecognized tax benefit as current versus long term is determined based on the expected timing of cash payments, if any. That is, to the extent that cash payments are anticipated within 12 months of the reporting date, a liability for an unrecognized tax benefit is classified as a current liability. Otherwise, such amounts are reflected as noncurrent liabilities or, in some cases, as reductions of refundable amounts or carryforwards. Additionally, ASC 740-10-45-11 states that the liability for unrecognized tax benefits shall not be combined (i.e., netted) with deferred tax liabilities or assets.

In determining balance sheet classification, management’s “real world” expectation of future cash payments should be used. For example, if $40 of a $100 liability for an unrecognized tax benefit is anticipated to be paid within 12 months, only $40 should be classified as a current liability, while the remaining $60 should be classified as a noncurrent liability. Similarly, if management’s expects that its liability for an unrecognized tax benefit will reverse without cash consequences within 12 months (e.g., because the statute of limitation will expire or the taxing authority will concede the position taken), the associated liability should be classified as noncurrent because no cash payments are anticipated to settle the liability.

The liability that an entity records for uncertain positions is not a component of deferred taxes. Therefore, it is inappropriate to use a valuation allowance to recognize a liability for an unrecognized tax benefit. Rather, the liability must be classified separately from other tax balances based on the expected timing of cash payments to taxing authorities.

See Section TX 15.5.1.5 for additional guidance related to disclosure of unrecognized tax benefits.

16.7.1.1 SEC Required Balance Sheet Display of Liabilities for Unrecognized Tax Benefits

Rule 5-02 of Regulation S-X provides the SEC’s requirements as to what should appear on the face of the balance sheet and in the related notes (i.e., balance sheet line items and certain related disclosures). The SEC staff has indicated that for the purposes of complying with the balance sheet display requirements, a registrant should display potential future obligations to taxing authorities as “Other Current Liabilities” (“taxes” are specifically referenced in paragraph 20 of Rule 5-02) or “Other Liabilities” (as per paragraph 24 of Rule 5-02), in addition to any other disclosures required on the face of the balance sheet or in footnotes (e.g., separately presenting an item in excess of 5 percent of current liabilities or in excess of 5 percent of total liabilities).

Example 16-16: Classifying a Liability for an Unrecognized Tax Benefit When
No Cash Payment Is Expected and Statute of Limitations Will Expire Within
the Next Twelve Months

Background/Facts:

In applying the recognition criterion of ASC 740-10-25, Company A has determined that a tax position resulting in a $1,000 tax benefit does not qualify for recognition. Company A is not currently under examination and does not expect to be examined by taxing authorities. The statute of limitations on assessment is set to expire in less than one year.

Question:

How should the liability related to this exposure be classified on the balance sheet?

Analysis/Conclusion:

Since the statute of limitations on the uncertain tax position is set to expire in less than one year and Company A believes that it will reverse without a cash payment (i.e., they expect to keep the $1,000 benefit), none of the liability attributable to this issue should be classified as “current.”

Example 16-17: Classifying the Current Portion of a Liability for an Unrecognized Tax Benefit With Some Cash Payment Expected

Background/Facts:

In applying the recognition criterion of ASC 740-10-25, Company A has determined that a tax position resulting in a $1,000 tax benefit does not qualify for recognition (and thus no benefit is recorded). Company A is currently under examination and expects to settle the issue with a cash payment of $600. The statute of limitations on assessment is set to expire in less than one year.

Question:

How should the liability related to this exposure be classified on the balance sheet?

Analysis/Conclusion:

Even though the entire liability is expected to reverse within the next year, only $600 (i.e., the expected cash payments to settle the issue) of the $1,000 liability should be reclassified from noncurrent to current on the balance sheet. To determine the amount of cash payment expected, all information should be considered, including the likelihood that the tax position will (or will not) be identified by taxing authorities.


16.7.2 Classification/Presentation of an Unrecognized Tax Benefit When NOL or Tax Credit Carryforwards Exist

If an entity has NOL carryforwards and an unrecognized tax benefit, should the unrecognized tax benefit be presented as a liability or a reduction of the NOL carryforward? The answer to this question depends on the specific facts and circumstances surrounding the carryforwards and the unrecognized tax benefit.

16.7.2.1 NOL (or Tax Credit Carryforwards) Directly Attributable to the Unrecognized Tax Benefit

For balance sheet purposes, NOLs, capital loss carryforwards, and tax credit carryforwards that are created or increased because of an unrecognized tax benefit should be recorded at the amount that is recognizable under the ASC 740 recognition and measurement model. Consistent with ASC 740-10-25-16, if a carryforward is created or increased as a result of an unrecognized tax benefit taken (or expected to be taken) on the tax return, the balance sheet should not reflect the DTA for the carryforward or the liability for the unrecognized tax benefit. However, the unrecognized tax benefit should be disclosed for the purposes of applying ASC 740-10-50-15.

The example below illustrates a specific fact pattern in which presentation of an unrecognized tax benefit as a reduction of a tax credit carryforward would be the appropriate accounting treatment.

Example 16-18: NOL/Tax Credit Carryforwards Should Be Recorded Net of Unrecognized Tax Benefits

Background/Facts:

Company A is a public company and has generated $1,000 of research-and-experimentation (R&E) credits that it plans to claim in its current-year income tax return. The company is in an NOL position even before the R&E credit is considered. The company has concluded that a full valuation allowance against the DTA related to the R&E credits (and NOLs) is necessary, as it does not expect to have sufficient taxable income to recognize the benefit from these items.

Under ASC 740-10-25, the R&E credit meets the more-likely-than-not criteria. Applying ASC 740-10’s measurement criteria results in $800 as the maximum benefit that is more than 50 percent likely to be realized. Therefore, $200 constitutes an unrecognized tax benefit.

Question:

How should Company A record the recognition of the R&E benefit?

Analysis/Conclusion:

Company A should record a DTA of $800, and no liability for the unrecognized benefit. Consistent with ASC 740-10-25-16, if a carryforward is created or increased as a result of an uncertain tax benefit taken (or expected to be taken) on the tax return, the balance sheet should not reflect the DTA for the carryforward or the liability for the unrecognized tax benefit. In this case, since the unrecognized tax benefit of $200 increased the R&E credit carryforward in the current year, it would not be recognized as part of the DTA and a liability would not be recognized for it.

Company A would record the following entries:

Journal Entry #1—This entry illustrates how to record the deferred tax benefit for the R&E benefit.


Journal Entry #2—This entry illustrates how to record the valuation allowance on the R&E benefit recognized.


In this case, Company A’s tabular reconciliation of unrecognized tax benefits would include the $200 unrecognized tax benefit, even though the footnote disclosure will not relate to the liability recorded on the balance sheet (In fact, in this case, no liability is recorded). Additionally, in the overall income tax disclosure, the credit carryforward amount disclosed would be $800 (i.e., the portion that satisfies ASC 740’s recognition and measurement threshold).

16.7.2.2 NOL (or Tax Credit Carryforwards) Not Directly Attributable to the Unrecognized Tax Benefit

An unrecognized tax benefit might not directly create or increase an NOL or tax credit carryforward. For example, an NOL or tax credit carryforward might exist from a previous period and be unrelated to an unrecognized tax benefit attributable to a current period tax position, or vice versa. In such cases, the financial statements will report a liability for unrecognized tax benefits for tax positions that fail to meet the recognition threshold, or that meet the recognition threshold but for which measurement causes partial benefits to be recorded in the financial statements. If settled with the taxing authority on the basis recognized and measured, the positions’ resolution effectively amounts to additional taxable income. Therefore, unrecognized tax benefits are effectively viewed as an additional source of taxable income that should be considered in the assessment of whether a DTA is realizable.

For example, if settled in the taxing authority’s favor, an uncertain tax position would result in additional taxable income for the prior period that may be absorbed by a carryback of an unutilized NOL that has a full valuation allowance. That is, the NOL would require a full valuation allowance absent the unrecognized tax benefits relating to the liability. It is important to evaluate the attributes and timing of the unrecognized tax benefit when considering it as a source of income (e.g., an uncertain tax benefit for ordinary income would not be a source of income for a capital loss carryforward in a U.S. tax jurisdiction).

The liability for an unrecognized tax benefit that is unrelated to a DTA, but allows for the realization and utilization of a DTA, is recorded separately. That is, even though the NOL can be applied to the liability if the uncertain tax position is not sustained, the NOL and the liability would be recorded separately on the balance sheet. (Refer to the PwC Observation below for recent standard setting developments on this topic). It should be noted, however, that interest on the liability would not generally require accrual, as long as the taxpayer is able to offset the exposures with NOLs.

The examples below illustrate specific fact patterns in which the recognition of a liability for an unrecognized tax benefit would be the appropriate accounting treatment.


Example 16-19: NOL/Tax Credit Carryforwards Recorded Gross of Unrecognized Tax Benefits

Background/Facts:

As of December 31, 20X7, Company A has $100 of NOL carryforwards that have been fully recognized under ASC 740-10-25 (i.e., as of December 31, 20X7, Company A has on its books a DTA of $40, assuming a 40 percent tax rate). The DTA does not require a valuation allowance. During 20X8, Company A has $0 taxable income after taking a deduction of $80 that does not meet the more-likely-than-not recognition criteria under ASC 740-10-25 for financial statement purposes.

Question:

Since the $100 NOL from 20X7 would be available to Company A if the 20X8 position were ultimately disallowed, should Company A net the $80 unrecognized tax benefit (UTB) resulting from 20X8 activity against the $100 NOL carried forward from 20X7? This would leave a gross NOL of $20 ($8 deferred tax asset) as of December 31, 20X8.

Analysis/Conclusion:

No. As of December 31, 20X8, Company A should record a liability of $32 ($80 x 40%) for the uncertain tax position expected to be taken on the 20X8 return and should leave the $40 (40% x $100) NOL carryforward previously recognized as a deferred tax asset. The rationale for gross presentation in this circumstance is premised on the fact that the NOLs from 20X7 continue to be valid tax attributes and may be used to offset another source of taxable income in a future period (prior to the final resolution of the uncertain position from 20X8). We understand that this conclusion is consistent with the view of the FASB staff.

In this case, interest typically would not be recorded on the liability for the unrecognized tax benefit, as the availability of the NOL would be considered in determining the amount of interest, if any, to accrue. That is, in many jurisdictions, such as the United States, the taxing authority would allow the tax preparer to amend its tax return and apply the NOL carryforward toward the liability. In this case, as there are sufficient NOLs to cover the liability, no interest would be recorded.

It is important to note that the balance sheet guidance above would only be applicable if the NOL and the uncertain tax positions arose in different tax years. If the uncertain tax position were entered into in the same tax year in which the NOL arose (i.e., absent the uncertain tax position, there would not have been a loss generated in a particular year), a net presentation would be required as described in Section TX 16.7.2.1. That is, the NOL DTA would be presented net of the unrecognized tax benefit, as described in ASC 740-10-25-16.

Example 16-20: NOL/Tax Credit Carryforwards in a Full Valuation Allowance Position Should Be Recorded Gross of Unrecognized Tax Benefits

Background/Facts:

As of December 31, 20X7, Company A has $800 in NOL carryforwards that have been fully recognized under ASC 740-10-25. These DTAs have attracted a full valuation allowance as a result of the significant negative evidence that exists.

In 20X8, Company A expects to report taxable income of $30 on its tax return. This taxable income of $30 includes a $10 deduction that does not meet the ASC 740-10-25 recognition threshold and therefore constitutes an unrecognized tax benefit. Assume that the tax rate is 40 percent and that the assessment of the need for a full valuation allowance has not changed as of December 31, 20X8.

Question:

Should Company A reduce the NOL carried forward from 20X7 on its balance sheet for the unrecognized tax benefit recorded in 20X8?

Analysis/Conclusion:

No. The Company should recognize the NOL carryforwards separately from the liability of $4. The $4 liability would be a source of income for the purposes of assessing whether a valuation allowance is necessary for the NOL carryforwards. The rationale for gross presentation in this circumstance is premised on the fact that the NOLs from 20X7 continue to be valid tax attributes and may be used to offset another source of taxable income in a future period (prior to the final resolution of the uncertain position from 20X8). This view is also consistent with the FASB staff view.

Journal Entries are summarized as follows:

Journal Entry #1—This entry illustrates how to record the realization of the NOL carryforward and the release of the valuation allowance due to 20X8 taxable income on tax return of $30 ($30 x 40% = $12).



Journal Entry #2—This entry illustrates how to record the liability on the unrecognized tax benefit of $10 ($10 x 40% = $4) taken in 2008.


Journal Entry #3—This entry illustrates how to reverse a valuation allowance of $4 due to the existence of a liability for the unrecognized tax benefit of $4, which can be used as a source of taxable income in the valuation allowance assessment.


Balance sheet reporting as of December 31, 20X8, is as follows:


16.7.2.3 Unrecognized Tax Benefits and Windfall Tax Benefits That Have Not Yet Reduced Taxes Payable

As further described in Section TX 18.14, an entity cannot recognize the excess tax benefit that results from the settlement of a stock-based compensation award until it reduces income taxes payable. In such cases, NOL carryforwards for which a deferred tax asset is recognized will differ from the amount of NOL carryforwards available to the entity (as disclosed in the entity’s tax return). While a liability for unrecognized tax benefits may provide a source of income when assessing the realizability of deferred tax assets attributable to NOL carryforwards (see Section TX 16.7.2.2), the liability does not create or increase taxes currently payable on a tax return. Therefore, unrecognized tax benefits do not provide a basis to recognize excess tax benefits that have not otherwise reduced taxes payable.

Example 16-21: Recognition of ASC 718, Stock Compensation Windfall Tax Benefits Upon Recording a Liability for the Unrecognized Tax Benefit of an Unrelated Tax Position

Background/Facts:

Company A has taken a position on its tax return that is considered an uncertain tax position. In its assessment of ASC 740-10-25, Company A has determined that the position does not meet the more-likely-than-not criteria for recognition. Thus, Company A has recorded a liability for the full amount of the deduction taken. However, Company A has available but unrecognized windfall tax benefits from the exercise of nonqualified stock options that are available to offset any amounts that might be payable if the uncertain tax position is not sustained on the tax return. These windfall tax benefits meet the recognition and measurement criteria of ASC 740, but have not yet reduced taxes payable and thus have not been recognized pursuant to ASC 718-740-25-10.

Question:

Since the windfall tax benefits would reduce taxes payable if the uncertain tax position is not sustained, should Company A recognize the APIC credit for the windfall tax benefits that would offset any tax due (if the position is not sustained) and remove the liability for the unrecognized tax benefit?

Analysis/Conclusion:

No. Recording a liability for the unrecognized tax benefit does not create or increase taxes currently payable on a tax return. Therefore, consistent with ASC 718-740-25-10, the windfall tax benefits have not yet reduced taxes payable and should not be recognized. If and when the liability becomes currently payable on a tax return and the windfall benefits are expected to reduce what would otherwise have been a currently payable income tax, the windfall tax benefits should be recorded as an adjustment to APIC.

16.8 Disclosures

16.8.1 Annual Disclosures

Disclosures for uncertain tax positions are often regarded as highly sensitive and, as such, require the use of professional judgment. Although management might be concerned with including information in the financial statements that could be advantageous to a taxing authority examining its uncertain tax positions, it is important to recognize that stakeholders base their investment decisions on those same financial statements. ASC 740-10-50-15 addresses this tension in part by requiring a qualitative discussion of only those positions that management expects will change significantly within the next twelve months. Further, for public entities, the quantitative rollforward of unrecognized tax benefits is prepared on a worldwide aggregated basis. The required disclosures are further discussed in Section TX 15.5.

16.9 Intraperiod Allocation

16.9.1 Backwards Tracing

We believe that pursuant to ASC 740-20-45-3 “backwards tracing” for the tax effects of the equity items listed in ASC 740-20-45-11(c) through (f) also includes both favorable and unfavorable adjustments resulting from changes in the assessment of uncertain tax positions. For example, pursuant to ASC 740-20-45-11(d) , a reduction in recognized tax benefits relating to excess deductions from share-based compensation should be recorded in equity to the extent there is a pool of windfall tax benefits (this accounting treatment is also discussed in Section TX 18.16).

But what about items previously recorded in discontinued operations or other comprehensive income (e.g., foreign currency translation adjustments and unrealized gains/losses from available-for-sale securities)? It would appear that under these circumstances, backwards tracing would be prohibited; however, ASC 740-20 only addresses backwards tracing within the context of initial recognition (i.e., release of a valuation allowance).

For example, suppose that in a prior period a liability was established for an unrecognized tax benefit that related to and was reported as a component of discontinued operations. In a subsequent year in which there were no pretax discontinued operations, the previously unrecognized benefit would be able to be recognized. In this circumstance, the FASB staff has confirmed that there are two acceptable alternatives, depending on a company’s accounting policy, that can be used to account for current-period recognition of tax benefits associated with previously recorded discontinued operations.

A backwards tracing alternative is based on provisions in ASC 205-20-45-4 which requires that subsequent adjustments to contingencies recorded as part of prior-year discontinued operations be classified as discontinued operations in the period in which the subsequent adjustment is made. Thus, when applying ASC 205-20-45-4 to tax uncertainties, these uncertainties are interpreted as contingencies, whose subsequent resolution is reflected in that year’s financial statements as discontinued operations even in the absence of current-period pretax income or loss from discontinued operations (i.e., the income statement line item “income or loss from discontinued operations” would show a tax benefit, but no pretax income or loss).

The other alternative is based on the principle in ASC 740-10-45-20 under which the tax effects of any changes to the beginning of the year valuation allowance (as a result of a change in judgment) is generally recorded in continuing operations. Therefore, by analogy, the tax effects of a change in the opening balance of unrecognized tax benefits (including unrecognized tax benefits related to prior-period discontinued operations) should be recorded in current-period income/loss from continuing operations.

Therefore, with respect to uncertain tax positions from discontinued operations, as well as uncertain tax positions associated with both extraordinary items and items included in other comprehensive income, both alternatives are acceptable. The alternative selected, however, is an accounting policy and should therefore be applied consistently.

16.10 Indemnification Arrangements

Income tax indemnifications are contractual arrangements established between two parties whereby one party will reimburse the other for income taxes paid to a taxing authority related to tax positions that arose, typically, prior to the transaction. Income tax indemnifications can arise from a number of circumstances including business combinations, spin-offs and IPOs. Common scenarios including the general direction of indemnification arrangements are summarized below:


The accounting for indemnification arrangements described below differs from the accounting that would result if the entity purchased insurance coverage from a third party to mitigate its exposure. In that situation, the entity should consider the guidance in ASC 720-20, Insurance Costs. Indemnification arrangements may also arise in a number of commercial or financing transactions such as leases; however, the accounting for such arrangements is not addressed below.

16.10.1 Accounting Considerations from the Indemnifying Party’s Perspective

16.10.1.1 Determining the Applicable Accounting Model

When determining which accounting to apply, consideration should be given to the relationship with the taxing authority and the relationship between the parties to the arrangement.

The indemnifying party must determine whether it is a primary obligor to the taxing authority. In situations when an entity that previously filed a separate tax return is sold to a third party or spun-off to shareholders, the determination may be clear. For example, when a U.S. company sells its interest in a foreign subsidiary, the consolidated entity generally has no legal obligation to pay back taxes in the foreign jurisdiction subsequent to the sale.

In situations when the transferred entity was previously included as part of a consolidated return, the determination may be less clear and more than one party may be considered a primary obligor. If a company is a primary obligor to the taxing authority, it should account for the tax risk pursuant to the provisions within ASC 740, Income Taxes (ASC 740)7 dealing with accounting for uncertain tax positions. Sections TX 16.3 and 16.4 discuss in detail the two-step recognition and measurement approach set out in ASC 740.

7 If the tax is determined to be a non-income based tax, a similar analysis will need to be performed; however, the guidance in ASC 740 should not be followed. Rather, accounting guidance such as ASC 450 may need to be applied.

If an indemnifying party is not a primary obligor to the taxing authority, it should account for the tax risk pursuant to ASC 460, Guarantees (ASC 460), which requires use of fair value based upon the guidance in ASC 820, Fair Value Measurements and Disclosures (ASC 820). The scope of ASC 460 does not apply to an indemnification issued between a parent and its subsidiary or between companies under common control. When considering whether ASC 460 applies, companies should note that the SEC staff has indicated that the above scope exception applies only during the parent-subsidiary relationship. For example, if a parent indemnifies a subsidiary prior to a spin-off, a decision to retain the guarantee post spin-off is the same as issuing a new guarantee at the date of the transaction when the parent-subsidiary relationship no longer exists. As a result, ASC 460 would apply subsequent to the spin-off.

If the ASC 460 (parent-subsidiary) scope exception applies, a company should account for the indemnification pursuant to ASC 450, Contingencies (ASC 450). ASC 450 requires a company to accrue a liability when it is probable that the liability has been incurred and the amount of loss can be reasonably estimated.

The following summarizes the paths to the relevant accounting guidance:

Is the company a primary obligor to the income taxing authority?

a. Yes. ASC 740 applies.

b. No. Is the arrangement between a parent and subsidiary or companies under common control?

i. Yes. ASC 450 applies.

ii. No. ASC 460 applies.

A change in circumstances causing a change in the applicable principle may result in adjusting or recognizing (and possibly reclassifying) a liability. For example, a company that was previously a primary obligor may have recorded a liability for unrecognized tax benefits pursuant to ASC 740. Following a disposition, the company is no longer a primary obligor to the taxing authority but agrees to indemnify the buyer. The company would need to adjust its liability to reflect an
ASC 460 approach.

16.10.1.2 Unique Considerations for Entities That Previously Filed as Part of a Consolidated Return

The situation may arise when a wholly owned subsidiary that was previously included as a member of a consolidated federal income tax return is spun off from its parent. In such a case, the subsidiary (Company B) may agree to indemnify the parent (Company A) for any income taxes that Company A may be assessed related to the resolution of Company B’s pre-spin uncertain tax positions. Further, because the entities were previously included as part of a consolidated return, under current U.S. tax law both Company A and Company B may be considered a primary obligor.

Indemnification—In general, when considering the subsidiary’s indemnification of the parent, we do not believe it would be appropriate for Company B to record a liability for the income taxes related to Company A’s operations. Although legally Company B may be liable for the taxes of Company A (i.e., because it is liable for the taxes of the entire pre-spin consolidated group), the convention under U.S. GAAP is that each entity should recognize income taxes related to its own operations. However, if Company A becomes insolvent (and, therefore, the taxing authority’s only recourse is to seek recovery from Company B), it may be appropriate for Company B to account for the potential liability related to Company A’s tax uncertainties as a contingent liability in accordance with ASC 450.

Primary obligor—As described in Section TX 16.10.1.1, if a company is a primary obligor to the taxing authority, it should account for the tax risk pursuant to the provisions within ASC 740, Income Taxes (ASC 740)8 dealing with accounting for uncertain tax positions.

8 If the tax is determined to be a non-income based tax, a similar analysis will need to be performed; however, the guidance in ASC 740 should not be followed. Rather, accounting guidance such as ASC 450 may need to be applied.

16.10.2 Accounting Considerations from the Indemnified Party’s Perspective

The indemnified party must also begin its analysis by determining whether they
are a primary obligor to the taxing authority and, if so, recognize and measure a liability in accordance with ASC 740. If the indemnifying and indemnified parties
are both liable for the exposure, both parties should apply the guidance in
ASC 740. The indemnified party must then determine the amount to recognize for the indemnification receivable.

The relevant accounting guidance for the indemnified party may differ depending on whether the transaction is accounted for as a business combination.

16.10.2.1 Business Combinations (ASC 805)

ASC 805 provides guidance on the recognition and measurement of an indemnification asset and requires what is sometimes referred to as “mirror image” accounting for indemnifications. The indemnified party recognizes an indemnification asset at the same time that it recognizes the indemnified item and measures the asset on the same basis as the indemnified item. Accordingly, an indemnification asset related to an uncertain tax position is recognized at the same time and measured on the same basis as the related liability, subject to collectability or contractual limitations on the indemnified amount. The liability is recognized and measured using the ASC 740 guidance. Indemnification assets recognized on the acquisition date continue to be measured on the same basis as the related indemnified item until they are collected, sold, cancelled, or expire.

Mirror image accounting assumes that the terms of the indemnification arrangement fully cover the related exposure. Where that is not the case, there can be accounting differences, such as in the following scenarios:

An income tax uncertainty relates to the timing of a deduction. For example, a tax deduction was claimed in year 1, but there is risk that the deduction should be taken over 15 years. Where the indemnification covers the implied interest cost associated with spreading the deduction over a longer period, the indemnification asset would not equal the related liability. Rather, in this case, the indemnification receivable would presumably equal only the outstanding interest accrual.

The indemnification covers any tax exposure that exceeds a specified dollar amount. In this situation, the mirror image will apply only to the excess over the specified amount.

There may also be scenarios where the terms of the indemnification fully cover the tax exposure, but the related amounts recorded for accounting purposes appear to differ, such as in the following scenarios:

A company does not classify interest and penalties in the same line as the liability for an income tax exposure. In this situation, mirror image accounting may apply (assuming that interest and penalties are covered by the indemnification); however, the indemnification asset would mirror the total of the tax liability and the related interest and penalty accruals.

The company records a reserve against the indemnification asset due to collection risk.

There may also be scenarios where the seller provides a blanket indemnification for taxes owed in prior years, but no specific tax positions are reserved. If no liability is required under the uncertain tax position guidance in ASC 740, an indemnification asset should not be recognized. Accordingly, the indemnification asset would be zero, which is the mirror image of the tax liability.

Another scenario to consider is when the income tax uncertainty increases a loss carryforward. In this situation, the guidance in ASC 740 requires a net presentation (i.e., the company should not record a deferred tax asset for the loss carryforward and a liability for the tax uncertainty). However, if the tax liability is covered by an indemnification, the indemnification asset would mirror the tax liability even though no tax liability is recorded. For example, assume that a buyer acquires a $100 loss carryforward (tax-effected). The buyer determines that $20 of the loss carryforward is an unrecognized tax benefit and, therefore, reduces the loss carryforward to $80. If the seller indemnifies the buyer for the related tax exposure, the buyer would record a $20 indemnification asset.

16.10.2.2 Transactions Other Than Business Combinations

The guidance in ASC 805 is limited to business combinations and, therefore, does not apply to transactions such as spin-offs or asset acquisitions. Accordingly, the question arises whether mirror image accounting should be applied to transactions other than business combinations.

In connection with the implementation of ASC 740’s guidance related to uncertain tax positions, certain investment funds approached the SEC for guidance on how to measure an indemnification receivable. In certain situations, in an effort to neutralize the impact of a tax exposure to a fund’s net asset value (NAV), the fund manager was willing to indemnify the fund for the exposure. In a letter to the funds,9 the SEC staff noted that “an advisor’s (or other relevant party’s) contractual obligation to indemnify uncertain tax positions generally would be sufficient in demonstrating that the likelihood of recovery is probable. The process of obtaining a contractual obligation to indemnify uncertain tax positions may occur simultaneously while the fund is gathering the relevant information to assess whether a liability should be recorded to NAV. In these circumstances, recognition of an indemnification receivable, to the extent of recovery of the tax accrual, generally would be acceptable practice.” The SEC’s letter provides support for recognizing the indemnification receivable at the same amount as the recorded liability absent any collectability or contractual limitations on the indemnified amount.

9 The SEC staff response was from Richard F. Sennett, Chief Accountant—Division of Investment Management and Conrad Hewitt—Chief Accountant. The response was dated June 28, 2007, and can be accessed at http://www.sec.gov/divisions/investment/fin48_letter_062807.htm.

A more common indemnification scenario, outside of a business combination, is when a parent spins off a subsidiary. Following the spin-off, the parent may indemnify the new entity for income tax exposures related to the spun-off entity’s prior operations. Assuming that the indemnification fully covers the exposure, we believe that it would be reasonable for the spun-off entity to record an indemnification receivable at the same amount as the tax liability. This view is consistent with the SEC’s letter described above.

Another scenario to consider, which might occur in an IPO, spin off or in a case involving an investment fund, is when the parent retains a controlling interest and, therefore, the parent-subsidiary relationship continues after the transaction. If the parent indemnifies the subsidiary, consideration should be given to whether the indemnification asset and subsequent changes should be recorded in equity.

16.10.3 Tax Consequences from Indemnification Payments

From a U.S. tax perspective, there are typically no consequences from indemnification payments regardless of whether the acquisition was taxable or nontaxable. For example, assume that an uncertain tax position is not sustained and that the buyer (or acquired company) pays $100 to the taxing authority and collects $100 from the seller. The amount paid to the taxing authority and the amount collected from the seller would generally offset, with no net impact on taxable earnings, tax-deductible goodwill or stock basis.

As a result, in most cases the indemnification receivable recorded in acquisition accounting would not be expected to have a deferred tax effect.

16.10.4 Financial Statement Presentation and Disclosure

An indemnification asset should not be netted against the related liability. Adjustments to the indemnification asset should be recorded in pre-tax income, not as part of income tax expense. The income tax line item is reserved for only those amounts expected to be paid to (or received from) the taxing authorities. Therefore, although dollar-for-dollar changes in an income tax liability and a related indemnification asset will offset on an after-tax basis, pre-tax income measures and a company’s effective tax rate will be impacted.

Companies should ensure that liabilities for unrecognized tax benefits, regardless of whether covered by an indemnification agreement, are included in the company’s annual disclosures. That is, the disclosures required by ASC 740-10-50-15 would reflect the unrecognized tax benefits with no offset or netting for an indemnification. For example, the company would need to include the tax position in its disclosure of gross amounts of increases and decreases in unrecognized tax benefits and amounts that, if recognized, would affect the effective tax rate. However, it may often be necessary to provide additional disclosure in regard to the terms of any indemnification arrangements so that financial statement readers can appropriately assess the net economic exposure to the entity.

16.11 Documentation

The level of effort and documentation that is required as part of the recognition and measurement process is a source of concern for many entities. Because there are an infinite number of possible exposures and several different taxing authorities, it is very difficult to develop guidance that is both specific and directly applicable to uncertain tax positions.

While ASC 740-10-25-6 states that the recognition of a tax benefit represents a positive assertion that an entity is entitled to the benefit, it does not impose specific documentation requirements for all tax positions with respect to the analysis performed for recognition or measurement purposes. However, entities should have a process in place for reviewing tax returns and other information to identify the position that should be evaluated under the requirements of ASC 740-10-25. In addition, entities should have procedures surrounding decisions and the review of those decisions reached in the recognition and measurement steps. Extensive analysis and documentation may not be necessary to support the recognition and measurement of positions supported by clear and unambiguous tax law. On the other hand, more robust analysis and documentation may be necessary if a position involves a significant amount of uncertainty. The extent of effort that may be required to analyze and document a tax position may depend significantly on the entity’s prior accounting policies and procedures.

Management will need to be able to support its accounting conclusions with an assessment of every material uncertainty and expected outcome. However, judgment will be required to determine how the entity should document those uncertainties. Sometimes, it is obvious that certain positions will be accepted. In those cases, the effort required to document will prove less burdensome. Other times, determining whether certain positions will be accepted requires a greater documentation effort and an in-depth analysis of the position, related tax laws, regulations, and case law. In these cases, the following points may be worth considering:

Due to the sheer number of positions and the significance of income taxes for the average entity, we believe that identification, assessment, and documentation of uncertain tax positions must be deeply integrated in an entity’s internal control structure.

Entities should consider beginning assessment and documentation efforts as soon as a significant position is initiated. Assessment and documentation should never be an afterthought in the processing of a transaction for financial reporting purposes.

The assessment of sustainability for classes of similar exposures or commonly recurring uncertain tax positions might be documented in a standard memo. This would allow transaction-specific criteria or unique issues to be addressed in more concise documentation that references the standard memo.

Entities might call on their experiences with other areas of GAAP, such as hedge accounting, which requires a diligent and detailed documentation regime.

16.11.1 Role and Use of Tax Opinion Letters

A tax opinion letter speaks not only to the merits of the tax position under applicable laws and regulations, but also to whether the related position has been properly structured in accordance with the tax law. A tax opinion letter must take into account all possible lines of attack by tax authorities, including their ability to disregard or re-characterize a transaction for lack of business purpose or economic substance.

In the United States, these possible lines of attack would include the technical aspects of the tax law and the structure of the related transaction (as discussed above), as well as whether the transaction meets the business-purpose test. Furthermore, U.S. federal tax authorities have challenged transactions when they have been able to establish that the transaction was counter to the original intent of the tax law.

We believe that all of these risks should be considered in evaluating whether it is more-likely-than-not that an uncertain tax position will be sustained. Just as a tax opinion letter cannot consider the possibility that the entity’s tax returns might not be audited or that the tax position might be settled as part of the tax audit for something less than the full benefit, an assessment of whether it is more-likely-than-not that an uncertain tax position will be sustained should not consider these possibilities.

It is also important to note that the terms used in tax opinion letters may have meanings that are different from the meanings of similar or identical terms used in financial accounting guidance. Entities obtaining tax opinions should have a clear understanding of the level of assurance that the advisor intends to convey. Although tax opinions do not need to conform to ASC 740, we would expect that many entities will use them to support conclusions reached on material, complex, and highly technical matters of income tax law.