Chapter 4 — Uncertainty in Income Taxes
Chapter 4 — Uncertainty in Income Taxes
4.1 Overview and Scope
As discussed in Chapter 1, an entity’s overall objectives in the accounting for
income taxes are to (1) “recognize the amount of taxes payable or refundable for the
current year” and (2) “recognize deferred tax liabilities and assets for the future
tax consequences of events that have been recognized in an entity’s financial
statements or tax returns.” The total tax provision includes current tax expense
(benefit) (i.e., the amount of income taxes paid or payable [or refundable] for a
year as determined by applying the provisions of the enacted tax law to the taxable
income or the excess of deductions over revenues for that year) and deferred tax
expense (or benefit) (i.e., change in DTAs and DTLs during the year). The total tax
expense reported in the financial statements should reflect the income tax effects
of tax positions on the basis of the two-step process in ASC 740-10, recognition
(step 1) and measurement (step 2). The recognition and measurement requirements of
ASC 740 should be applied only to uncertainties in income taxes and do not apply to
non-income taxes such as sales tax, value-added tax, and payroll tax.
See Section 11.4 for a
discussion of the accounting for uncertainty in income taxes in business
combinations.
4.1.1 UTB Decision Tree and Assumptions in Recognition and Measurement
The decision tree below provides an overview of the process for
recognizing the benefits of a tax position under ASC 740.
The table below summarizes the framework an entity uses when
applying the two-step process of recognition and measurement under ASC
740-10.
|
Step 1 — Recognition
|
Step 2 — Measurement
|
|---|---|
|
The position will be examined
|
Same
|
|
The examiner will have full knowledge of
all relevant information
|
Same
|
|
Offsetting or aggregating tax positions
should not be considered
|
Same
|
|
The evaluation should be based solely on
the position’s technical merits
|
The evaluation should be based on all
relevant information available on the reporting date
|
|
It should be assumed that the position
will be resolved in a court of last resort
|
The conclusion should be based on the
amount the taxpayer would ultimately accept in a
negotiated settlement with the tax authority
|
4.1.2 Consideration of Tax Positions Under ASC 740
ASC 740 applies to all tax positions in a previously filed tax return or tax
positions expected to be taken in a future tax return. A tax position can result
in a permanent reduction of income taxes payable, a deferral of income taxes
otherwise currently payable to future years, or a change in the expected
realizability of DTAs.
The definition of “tax position” in ASC 740-10-20 also lists the
following examples of tax positions that are within the scope of ASC 740:
-
“A decision not to file a tax return” (e.g., a decision not to file a specific state tax return because nexus was not established).
-
“An allocation or a shift of income between jurisdictions” (e.g., transfer pricing).
-
“The characterization of income or a decision to exclude reporting taxable income in a tax return” (e.g., interest income earned on municipal bonds).
-
“A decision to classify a transaction, entity, or other position in a tax return as tax exempt” (e.g., a decision not to include a foreign entity in the U.S. federal tax return).
-
“An entity’s status, including its status as a pass-through entity or a tax-exempt not-for-profit entity.”
Uncertainties related to tax positions not within the scope of ASC 740, such as
taxes based on gross receipts, revenue, or capital, should be accounted for
under other applicable literature (e.g., ASC 450).
4.1.2.1 Tax Positions Related to Entity Classification
Many entities are exempt from paying taxes because they
qualify as either a tax-exempt (e.g., not-for-profit organization) or a
pass-through entity (e.g., Subchapter S corporation, partnership), or they
function similarly to a pass-through entity (e.g., REIT, RIC). To qualify
for tax-exempt or pass-through treatment, such entities must meet certain
conditions under the relevant tax law.
According to the definition of a tax position in ASC 740-10-20, a decision to
classify an entity as tax exempt or as a pass-through should be evaluated
under ASC 740 for recognition and measurement. In some situations, it may be
appropriate for the entity to consider how the administrative practices and
precedents of the relevant tax authority could affect its qualification for
tax-exempt or pass-through treatment.
For example, a Subchapter S corporation must meet certain conditions to
qualify for special tax treatment. If the Subchapter S corporation violates
one of these conditions, it might still qualify for the special tax
treatment under a tax authority’s widely understood administrative practices
and precedents. Sometimes, however, these administrative practices and
precedents are available only if an entity self-reports the violation. In
assessing whether self-reporting affects an entity’s ability to avail itself
of administrative practices and precedents, the entity should consider
whether relief would still be as readily available if, before
self-reporting, the tax authority contacts the entity for an examination. If
an entity has the ability to pursue relief, and the likelihood of relief is
not compromised even if, before self-reporting, the tax authority makes
contact for an examination, then the entity can rely on these administrative
practices and precedents for recognition purposes because such
administrative practices and precedents are not contingent upon
self-reporting. However, if relief were no longer available, or the
likelihood of relief were compromised had the tax authority contacted the
entity for examination before self-reporting, then the administrative
practice would be contingent upon self-reporting, and the entity would not
be able to rely on these administrative practices and precedents for
recognition purposes until the violation had actually been
self-reported.
4.1.2.2 Unit of Account
Each individual tax position must be analyzed separately
under ASC 740. ASC 740-10-25-13 states that an entity’s determination of
what constitutes a unit of account for its individual tax position “is a
matter of judgment based on the individual facts and circumstances.” To
determine the unit of account, the entity should consider, at a minimum, (1)
the manner in which it prepares and supports its income tax return and (2)
the approach it expects the tax authorities will take during an examination.
The entity may also consider:
-
The composition of the position — whether the position is made up of multiple transactions that could be individually challenged by the tax authority.
-
Statutory documentation requirements.
-
The nature and content of tax opinions.
-
The history of the entity (or reliable information about others’ history) with the relevant tax authority on similar positions.
The determination of the unit of account to which ASC 740 is applied is not
an accounting policy choice; rather, it is a factual determination that is
based on the facts and circumstances for the tax position being considered.
Every tax position (e.g., transaction, portion of transaction, election,
decision) for which a tax reporting consequence is reported in the financial
statements is within the scope of ASC 740 and is, therefore, a possible unit
of account to which ASC 740 applies. The unit of account is determined by
evaluating the facts and circumstances of the tax position.
Once determined, the unit of account for a tax position should be the same
for each position and similar positions from period to period unless changes
in facts and circumstances indicate that a different unit of account is
appropriate.
Changes in facts and circumstances that could cause
management to reassess its determination of the unit of account include
significant changes in organizational structure (e.g., sale of a
subsidiary), recent experience with tax authorities, a change in tax law,
and a change in the regulatory environment within a jurisdiction.
Although ASC 740-10-55-87 through 55-89 acknowledge that changes in a unit of
account may occur, such changes are expected to be infrequent. Further, if a
change in unit of account is caused by something other than a change in
facts and circumstances, it may be an indication that ASC 740 was applied
incorrectly in prior periods.
A change in judgment regarding the appropriate unit of account that does not
result from the correction of an error should be treated as a change in
estimate and applied prospectively.
4.2 Recognition
ASC 740-10
25-5 This Subtopic requires the
application of a more-likely-than-not recognition criterion
to a tax position before and separate from the measurement
of a tax position. See paragraph 740-10-55-3 for guidance
related to this two-step process.
25-6 An entity shall initially
recognize the financial statement effects of a tax position
when it is more likely than not, based on the technical
merits, that the position will be sustained upon
examination. The term more likely than not means a
likelihood of more than 50 percent; the terms
examined and upon examination also include
resolution of the related appeals or litigation processes,
if any. For example, if an entity determines that it is
certain that the entire cost of an acquired asset is fully
deductible, the more-likely-than-not recognition threshold
has been met. The more-likely-than-not recognition threshold
is a positive assertion that an entity believes it is
entitled to the economic benefits associated with a tax
position. The determination of whether or not a tax position
has met the more-likely-than-not recognition threshold shall
consider the facts, circumstances, and information available
at the reporting date. 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.
25-7 In making the required
assessment of the more-likely-than-not criterion:
-
It shall be presumed that the tax position will be examined by the relevant taxing authority that has full knowledge of all relevant information.
-
Technical merits of a tax position derive from sources of authorities in the tax law (legislation and statutes, legislative intent, regulations, rulings, and case law) and their applicability to the facts and circumstances of the tax position. 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.
-
Each tax position shall be evaluated without consideration of the possibility of offset or aggregation with other positions.
25-8
If the more-likely-than-not recognition threshold is not met
in the period for which a tax position is taken or expected
to be taken, an entity shall recognize the benefit of the
tax position in the first interim period that meets any one
of the following conditions:
-
The more-likely-than-not recognition threshold is met by the reporting date.
-
The tax position is effectively settled through examination, negotiation or litigation.
-
The statute of limitations for the relevant taxing authority to examine and challenge the tax position has expired.
Accordingly, a change in facts after the reporting date but
before the financial statements are issued or are available
to be issued (as discussed in Section 855-10-25) shall be
recognized in the period in which the change in facts
occurs.
25-9 A
tax position could be effectively settled upon examination
by a taxing authority. Assessing whether a tax position is
effectively settled is a matter of judgment because
examinations occur in a variety of ways. In determining
whether a tax position is effectively settled, an entity
shall make the assessment on a position-by-position basis,
but an entity could conclude that all positions in a
particular tax year are effectively settled.
25-10
As required by paragraph 740-10-25-8(b) an entity shall
recognize the benefit of a tax position when it is
effectively settled. An entity shall evaluate all of the
following conditions when determining effective
settlement:
-
The taxing authority has completed its examination procedures including all appeals and administrative reviews that the taxing authority is required and expected to perform for the tax position.
-
The entity does not intend to appeal or litigate any aspect of the tax position included in the completed examination.
-
It is remote that the taxing authority would examine or reexamine any aspect of the tax position. In making this assessment management shall consider the taxing authority’s policy on reopening closed examinations and the specific facts and circumstances of the tax position. Management shall presume the relevant taxing authority has full knowledge of all relevant information in making the assessment on whether the taxing authority would reopen a previously closed examination.
25-11
In the tax years under examination, a tax position does not
need to be specifically reviewed or examined by the taxing
authority to be considered effectively settled through
examination. Effective settlement of a position subject to
an examination does not result in effective settlement of
similar or identical tax positions in periods that have not
been examined.
25-12
An entity may obtain information during the examination
process that enables that entity to change its assessment of
the technical merits of a tax position or of similar tax
positions taken in other periods. However, the effectively
settled conditions in paragraph 740-10-25-10 do not provide
any basis for the entity to change its assessment of the
technical merits of any tax position in other periods.
25-13
The appropriate unit of account for determining what
constitutes an individual tax position, and whether the
more-likely-than-not recognition threshold is met for a tax
position, is a matter of judgment based on the individual
facts and circumstances of that position evaluated in light
of all available evidence. The determination of the unit of
account to be used shall consider the manner in which the
entity prepares and supports its income tax return and the
approach the entity anticipates the taxing authority will
take during an examination. Because the individual facts and
circumstances of a tax position and of an entity taking that
position will determine the appropriate unit of account, a
single defined unit of account would not be applicable to
all situations.
25-14
Subsequent recognition shall be based on management’s best
judgment given the facts, circumstances, and information
available at the reporting date. A tax position need not be
legally extinguished and its resolution need not be certain
to subsequently recognize the position. Subsequent changes
in judgment that lead to changes in recognition shall result
from the evaluation of new information and not from a new
evaluation or new interpretation by management of
information that was available in a previous financial
reporting period. See Sections 740-10-35 and 740-10-40 for
guidance on changes in judgment leading to derecognition of
and measurement changes for a tax position.
25-15
A change in judgment that results in subsequent recognition,
derecognition, or change in measurement of a tax position
taken in a prior annual period (including any related
interest and penalties) shall be recognized as a discrete
item in the period in which the change occurs. Paragraph
740-270-35-6 addresses the different accounting required for
such changes in a prior interim period within the same
fiscal year.
25-16
The amount of benefit recognized in the statement of
financial position may differ from the amount taken or
expected to be taken in a tax return for the current year.
These differences represent unrecognized tax benefits. A
liability is created (or the amount of a net operating loss
carryforward or amount refundable is reduced) for an
unrecognized tax benefit because it represents an entity’s
potential future obligation to the taxing authority for a
tax position that was not recognized under the requirements
of this Subtopic.
25-17
A tax position recognized in the financial statements may
also affect the tax bases of assets or liabilities and
thereby change or create temporary differences. A taxable
and deductible temporary difference is a difference between
the reported amount of an item in the financial statements
and the tax basis of an item as determined by applying this
Subtopic’s recognition threshold and measurement provisions
for tax positions. See paragraph 740-10-30-7 for measurement
requirements.
Related Implementation Guidance and Illustrations
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Recognition and Measurement of Tax Positions — a Two-Step Process [ASC 740-10-55-3].
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Example 1: The Unit of Account for a Tax Position [ASC 740-10-55-81].
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Example 2: Administrative Practices — Asset Capitalization [ASC 740-10-55-90].
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Example 3: Administrative Practices — Nexus [ASC 740-10-55-93].
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Example 11: Information Becomes Available Before Issuance of Financial Statements [ASC 740-10-55-117].
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Example 32: Definition of a Tax Position [ASC 740-10-55-223].
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Example 33: Definition of a Tax Position [ASC 740-10-55-224].
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Example 34: Definition of a Tax Position [ASC 740-10-55-225].
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Example 35: Attribution of Income Taxes to the Entity or Its Owners [ASC 740-10-55-226].
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Example 36: Attribution of Income Taxes to the Entity or Its Owners [ASC 740-10-55-227].
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Example 37: Attribution of Income Taxes to the Entity or Its Owners [ASC 740-10-55-228].
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Example 38: Financial Statements of a Group of Related Entities [ASC 740-10-55-229].
An assessment of whether a tax position meets the more-likely-than-not recognition
threshold is based on the technical merits of the tax position. If that threshold is
not met, no benefit can be recognized in the financial statements for that tax
position.
When recognizing a tax position, an entity must assess the position’s technical
merits under the tax law for the relevant jurisdiction. That assessment often
requires consultation with tax law experts.
4.2.1 Meaning of the Court of Last Resort and Its Impact on Recognition
As part of the technical merit assessment, an entity must assess what the outcome
of a dispute would be if the matter was taken to the court of last resort.
According to ASC 740-10-55-3, the “recognition threshold is met when the
taxpayer (the reporting entity) concludes that . . . it is more likely than not
that the taxpayer will sustain the benefit taken . . . in a dispute with taxing
authorities if the taxpayer takes the dispute to the court of last resort.”
The court of last resort is the highest court that has
discretion to hear a particular case in a particular jurisdiction. In
determining whether a tax position meets the more-likely-than-not recognition
threshold, an entity must consider how the court of last resort would rule. To
form a conclusion, an entity must examine all laws against which the court of
last resort would evaluate the tax position.
In the United States, the U.S. Supreme Court, as the highest judicial body, is
the highest court that has discretion to hear an income-tax-related case. It is
thus the ultimate court for deciding the constitutionality of federal or state
law. Many more cases are filed with the U.S. Supreme Court than are heard; the
justices exercise discretion in deciding which cases to hear.
When evaluating the recognition criteria in ASC 740, an entity should not
consider the likelihood that the U.S. Supreme Court will hear a case regarding
the constitutionality of the applicable tax law. In assessing the tax position
for recognition, the entity should assume that the case will be heard by the
court of last resort.
The highest courts of jurisdictions outside the United States that hear
income-tax-related cases may not be these jurisdictions’ supreme courts. In
addition, in foreign jurisdictions, supreme courts may also not evaluate a case
against laws other than income tax laws. Tax positions should be evaluated
against all laws that apply in each relevant jurisdiction.
4.2.2 Legal Tax Opinions Not Required
An entity is not required to obtain a legal tax opinion to support its conclusion
that a tax position meets the recognition criteria in ASC 740-10-25-6. However,
the entity must have sufficient evidence to support its assertion that a tax
benefit should be recognized on the basis of the technical merits of the
relevant law. In addition, the entity should determine whether it has the
appropriate expertise to evaluate all available evidence and the uncertainties
associated with the relevant statutes or case law. The entity must use judgment
in determining the amount and type of evidence it needs in addition to, or in
lieu of, a tax opinion to demonstrate whether the more-likely-than-not
recognition threshold is met.
4.2.3 Consideration of Widely Understood Administrative Practices and Precedents
When assessing whether a tax position meets the more-likely-than-not recognition
threshold, an entity is allowed under ASC 740 to consider past administrative
practices and precedents only when the tax position taken by the entity could
technically be a violation of tax law but is known to be widely accepted by the
tax authority. An example of this concept is the tax authority’s accepting the
immediate deduction of the cost of acquired fixed assets that are below a
reasonable dollar threshold even though this may be considered a technical
violation of the tax law.
Because ASC 740 does not provide guidance on when an administrative practice and
precedent is considered “widely understood,” this assertion depends on the
specific facts and circumstances of the tax position; therefore, an entity must
use professional judgment to decide what constitutes “widely understood.” An
entity that asserts that an administrative practice and precedent is widely
understood should document the basis of that assertion, including the evidence
to support it. Such evidence may include reliable knowledge of the tax
authority’s past dealings with the entity on the same tax matter when the facts
and circumstances have been similar. The use of administrative practices and
precedents is expected to be infrequent.
With respect to administrative practices and precedents, the SEC
has indicated1 that if a tax authority objects to an entity’s tax position but has
previously granted prospective transition by indicating that no additional taxes
would be due for prior periods, the entity should “consider
the taxing authority’s practice of addressing fund industry issues on a
prospective basis as part of the administrative practices and precedents of
the taxing authority” (emphasis added) when analyzing the technical
merits of the specific tax position.
Footnotes
4.3 Measurement
ASC 740-10
30-7 A tax
position that meets the more-likely-than-not recognition
threshold shall initially and subsequently be measured as
the largest amount of tax benefit that is greater than 50
percent likely of being realized upon settlement with a
taxing authority that has full knowledge of all relevant
information. Measurement of a tax position that meets the
more-likely-than-not recognition threshold shall consider
the amounts and probabilities of the outcomes that could be
realized upon settlement using the facts, circumstances, and
information available at the reporting date. As used in this
Subtopic, the term reporting date refers to the date of the
entity’s most recent statement of financial position. For
further explanation and illustration, see Examples 5 through
10 (paragraphs 740-10-55-99 through 55-116).
4.3.1 Information Affecting Measurement of Tax Positions
In determining the largest amount of tax benefit that is more
than 50 percent likely to be realized upon ultimate settlement with a tax
authority, an entity should give more weight to information that is objectively
verifiable than to information that is not. The amount of tax benefit to
recognize in financial statements should be based on reasonable and supportable
assumptions. Some information used to determine the amount of tax benefit to be
recognized in financial statements (amounts and probabilities of the outcomes
that could be realized upon ultimate settlement) will be objectively determined,
while other amounts will be determined more subjectively. The weight given to
the information should be commensurate with the extent to which the information
can be objectively verified. Examples of objectively determined information
include the amount of deduction reported in an entity’s as-filed tax return or
the amount of deduction for a similar tax position examined by, or sustained in
settlement with, the tax authority in the past.
ASC 740-10-30-7 states, in part:
Measurement of a tax position . . . shall consider the amounts and
probabilities of the outcomes that could be realized upon [ultimate]
settlement using the facts, circumstances, and information available at
the reporting date.
Because of the level of uncertainty associated with a tax
position, unless the position is considered “binary” (see additional discussion
in Section 4.3.5), an entity will
generally need to perform a cumulative-probability assessment of the possible
estimated outcomes when applying the measurement criterion.
Because ASC 740 does not prescribe how to assign or analyze the probabilities of
individual outcomes of a recognized tax position, this process involves
judgment. Ultimately, an entity must consider all available information about
the tax position to form a reasonable, supportable basis for its assigned
probabilities. Factors an entity should consider in forming the basis for its
assigned probabilities include, but are not limited to, the amount reflected (or
expected to be reflected) in the tax return, the entity’s past experience with
similar tax positions, information obtained during the examination process,
closing and other agreements, and the advice of experts. The entity should
maintain the necessary documentation to support its assigned probabilities.
In any of the following circumstances, an entity may need to obtain third-party
expertise to assist with measurement:
-
The tax position results in a large tax benefit.
-
The tax position relies on an interpretation of law in which the entity lacks expertise.
-
The tax position arises in connection with an unusual, nonrecurring transaction or event.
-
The range of potential sustainable benefits is widely dispersed.
-
The tax position is not addressed specifically in the tax law and requires significant judgment and interpretation.
4.3.2 Cumulative-Probability Table
It is expected that an entity will perform a
cumulative-probability analysis when measuring its uncertain tax positions that
have met the recognition threshold in instances in which there is more than one
possible settlement outcome. Although the use of a cumulative-probability table
in the performance of such an analysis is not required, it is a tool that can
help management (1) assess and document the level of uncertainty related to the
outcomes of various tax positions and (2) demonstrate that the amount of tax
benefit recognized is consist with the guidance in ASC 740-10-30-7.
4.3.3 Cumulative-Probability Approach Versus Best Estimate
In the determination of the amount of tax benefit that will ultimately be
realized upon settlement with the tax authority, cumulative probability is not
equivalent to best estimate. While the best estimate is the single expected
outcome that is more probable than all other possible outcomes, the
cumulative-probability approach is based on the largest amount of tax benefit
with a greater than 50 percent likelihood of being realized upon ultimate
settlement with a tax authority.
The table in the example below illustrates this difference by
showing the measurement of the benefit of an uncertain tax position. Under the
cumulative-probability approach, the largest amount of tax benefit with a
greater than 50 percent likelihood of being realized is $20, while the best
estimate is $25 (the most probable outcome at 31 percent). An entity must use
the cumulative-probability approach when measuring the amount of tax benefit to
record under ASC 740-10-30-7.
Example 4-1
In its 20X7 tax return, an entity takes a $100 tax
deduction, which reduces its current tax liability by
$25. The entity concludes that there is a greater than
50 percent chance that, if the tax authority were to
examine the tax position, it would be sustained as
filed. Accordingly, the tax deduction meets the
more-likely-than-not recognition threshold.
Although the tax position meets the more-likely-than-not
recognition threshold, the entity believes that it would
negotiate a settlement if the tax position were
challenged by the tax authority. On the basis of these
assumptions, the entity determines the following
possible outcomes and probabilities:
Accordingly, the entity should (1) recognize a tax
benefit of $20 because this is the largest benefit that
has a cumulative probability of greater than 50 percent
and (2) record a $5 liability for UTBs (provided that
the tax position does not affect a DTA or DTL).
4.3.4 Use of Aggregation and Offsetting in Measuring a Tax Position
An entity may not employ aggregation or offsetting techniques that specifically
apply to multiple tax positions when measuring the benefit associated with a tax
position. Each tax position must be considered and measured independently,
regardless of whether the related benefit is expected to be negotiated with the
tax authority as part of a broader settlement involving multiple tax
positions.
4.3.5 Tax Positions That Are Considered Binary
A tax position is considered binary when there are only two possible outcomes
(e.g., full deduction or 100 percent disallowance).
Because tax authorities are often permitted — in lieu of
litigation — to negotiate a settlement with taxpayers for positions taken in
their income tax returns, very few tax positions are, in practice, binary. In
certain circumstances, however, it may be acceptable to evaluate the amount of
benefit to recognize as if the position was binary (e.g., when the tax position
is so fundamental to the operation of an entity’s business that the entity is
unwilling to compromise). Since such circumstances are expected to be rare, the
entity should use caution in determining whether a tax position should be
considered binary with respect to measuring the amount of tax benefit to
recognize.
If a tax position is considered binary and meets the
more-likely-than-not threshold for recognition, it is appropriate to consider
only two possible outcomes for measurement purposes: the position is sustained
or the position is lost. ASC 740-10-30-7 states, in part:
A tax position that
meets the more-likely-than-not recognition threshold shall initially and
subsequently be measured as the largest amount of tax benefit that is
greater than 50 percent likely of being realized upon settlement with a
taxing authority that has full knowledge of all relevant information.
Measurement of a tax position that meets the more-likely-than-not
recognition threshold shall consider the amounts and probabilities of the
outcomes that could be realized upon settlement using the facts,
circumstances, and information available at the reporting date.
While such situations are rare, when a tax position is considered binary and
meets the more-likely-than-not recognition threshold in ASC 740-10-30-7, that
tax position should be measured at the largest amount that is more than 50
percent likely to be realized, which would generally be the as-filed position
(i.e., full benefit).
Connecting the Dots
When a full tax benefit is recognized for a tax position that is
considered binary and no UTB is presented in the tabular UTB
reconciliation, the entity should consider disclosing additional
information for such tax positions that could have a significant effect
on the entity’s financial position, operations, or cash flows.
4.4 Interest (Expense and Income) and Penalties
ASC 740-10
30-29
Paragraph 740-10-25-56 establishes the requirements under which
an entity shall accrue interest on an underpayment of income
taxes. The amount of interest expense to be recognized shall be
computed by applying the applicable statutory rate of interest
to the difference between the tax position recognized in
accordance with the requirements of this Subtopic for tax
positions and the amount previously taken or expected to be
taken in a tax return.
30-30
Paragraph 740-10-25-57 establishes both when an entity shall
record an expense for penalties attributable to certain tax
positions as well as the amount.
4.4.1 Interest Expense
ASC 740-10-30-29 requires that an entity recognize and compute
interest expense by applying the applicable statutory rate of interest to the
difference between the tax position recognized in the financial statements, in
accordance with ASC 740, and the as-filed tax position.
Paragraphs B52 and B53 of Interpretation 48, which were not codified, explain that the FASB, during its redeliberations of the provisions of Interpretation 48, considered whether to require accrual of interest on (1) management’s best estimate of the amount that would ultimately be paid to the tax authority upon settlement or (2) the difference between the tax benefit of the as-filed tax position and the amount recognized in the financial statements. The FASB concluded that accruing interest on the basis of management’s best estimate would be inconsistent with the approach required in Interpretation 48 for recognizing tax positions and that the
amount of interest and penalties recognized should be consistent with the amount of
tax benefits reported in the financial statements.
4.4.2 Interest Income
ASC 740 does not discuss the recognition and measurement of interest income on UTBs;
however, an entity should recognize and measure interest income to be received on an
overpayment of income taxes in the first period in which the interest would begin
accruing according to the provisions of the relevant tax law.
4.4.3 Penalties
Penalties should be accrued if the position does not meet the minimum statutory
threshold necessary to avoid payment of penalties unless a widely understood
administrative practices and precedents exception (discussed below) is
applicable.
In many jurisdictions, penalties may be imposed when a specified
threshold of support for a tax position taken is not met. In the United States, some
penalties are transaction-specific (i.e., not based on taxable income) and others,
such as penalties for substantial underpayment of taxes, are based on the amount of
additional taxes due upon settlement with the tax authority. Taxing authorities may
also assess penalties that are unrelated to income taxes. For example, a taxing
authority may impose penalties associated with taxes that are outside the scope of
ASC 740 or that are related to informational filings. Penalties that are not related
to an income tax are not generally within the scope of ASC 740. Such penalties are
also not within the scope of the entity’s policy for presenting interest and
penalties in the income statement and balance sheet (see Section 13.3.1).
ASC 740-10-25-57 indicates that an entity must recognize, on the basis of the
relevant tax law, an expense for the amount of a statutory penalty in the period in
which the tax position that would give rise to a penalty has been taken or is
expected to be taken in the tax return. Penalties required under the relevant tax
law should thus be recorded in the same period in which the liability for UTBs is
recognized. If the penalty was not recorded when the tax position was initially
taken because the position met the minimum statutory threshold, the entity should
recognize the expense in the period in which its judgment about meeting the minimum
statutory threshold changes.
Example 4-2
On December 31, 20X7, a calendar-year-end entity expects to a
take a tax position that will reduce its tax liability in
its 20X7 tax return, which will be filed in 20X8. The entity
concludes that the tax position lacks the specified
confidence level (e.g., substantial authority) required to
avoid the payment of a penalty under the relevant tax law.
In its December 31, 20X7, financial statements, the entity
should record a liability for the penalty amount the tax
authority is expected to assess on the basis of the relevant
tax law.
An entity should consider a tax authority’s widely understood administrative
practices and precedents in determining whether the minimum statutory threshold to
avoid the assessment of penalties has been met. If the tax authority has a widely
understood administrative practice or precedent that modifies the circumstances
under which a penalty is assessed (relative to the statutory criteria), the entity
should consider this administrative practice or precedent in determining whether a
penalty should be assessed. Anecdotal evidence, such as the entity’s historical
experience with the tax authority in achieving penalty abatement, would not be
considered an administrative practice.
To take such a widely understood policy into consideration, the entity must conclude
that the tax authority would not assess penalties provided that the tax authority
has full knowledge of all the relevant facts. The use of such a policy is limited to
whether the tax authority would assess penalties. It does not apply to the
determination of the amount of penalties that the entity will actually pay once they
are assessed. That is, a tax authority’s historical practice of abating penalties
during negotiations with the entity when the threshold to avoid the assessment of
penalties has not been met is not relevant to the accrual and measurement of
penalties. If the entity concludes that penalties are applicable under ASC
740-10-25-56 because there is no widely understood policy, the entity must calculate
the penalties to accrue on the basis of the applicable tax code.
Example 4-3
A U.S. corporate entity applies the
provisions of ASC 740 to its tax positions and recognizes a
liability for its UTBs. The entity accrues interest by
applying the applicable statutory rate of interest to the
difference between the tax position recognized in the
financial statements, in accordance with ASC 740, and the
as-filed tax position. The entity identifies a written
policy in the tax authority’s manual that allows its field
agents to ignore the statute and not assess penalties when
an entity has a reasonable basis for its return position and
the tax authority has routinely applied the exception in
circumstances that are similar to the entity’s specific
situation. The entity should consider that policy when
determining whether it must accrue penalties related to its
UTBs.
Example 4-4
An entity applies the provisions of ASC 740
to its tax positions and recognizes a liability for its
UTBs. The entity accrues interest by applying the applicable
statutory rate of interest to the difference between the tax
position recognized in the financial statements, in
accordance with ASC 740, and in the as-filed tax position.
The entity did not meet the minimum statutory threshold to
avoid assessment of penalties; however, the entity’s past
experience indicates that it is probable that the tax
authority will abate all penalties assessed during the
examination process. The entity may not take its past
experience into consideration because it does not constitute
a widely understood administrative practice or precedent
relative to whether a penalty would be assessed under the
circumstances. Since the entity did not meet the minimum
statutory threshold to avoid the assessment of penalties,
the entity must accrue penalties on the basis of the
applicable statutory rate.
See Section 13.3.1 for a discussion related to presentation of
interest (expense and income) and penalties in the financial statements.
4.5 Subsequent Changes in Recognition and Measurement
ASC 740-10
35-2 Subsequent
measurement of a tax position meeting the recognition
requirements of paragraph 740-10-25-6 shall be based on
management’s best judgment given the facts, circumstances, and
information available at the reporting date. Paragraph
740-10-30-7 explains that the reporting date is the date of the
entity’s most recent statement of financial position. A tax
position need not be legally extinguished and its resolution
need not be certain to subsequently measure the position.
Subsequent changes in judgment that lead to changes in
measurement shall result from the evaluation of new information
and not from a new evaluation or new interpretation by
management of information that was available in a previous
financial reporting period.
35-3 Paragraph
740-10-25-15 requires that a change in judgment that results in
a change in measurement of a tax position taken in a prior
annual period (including any related interest and penalties)
shall be recognized as a discrete item in the period in which
the change occurs. Paragraph 740-270-35-6 addresses the
different accounting required for such changes in a prior
interim period within the same fiscal year.
40-2 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. 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.
Derecognition shall be based on management’s best judgment given
the facts, circumstances, and information available at the
reporting date. Paragraph 740-10-30-7 explains that the
reporting date is the date of the entity’s most recent statement
of financial position. Subsequent changes in judgment that lead
to derecognition shall result from the evaluation of new
information and not from a new evaluation or new interpretation
by management of information that was available in a previous
financial reporting period.
40-3 If an entity that had
previously considered a tax position effectively settled becomes
aware that the taxing authority may examine or reexamine the tax
position or intends to appeal or litigate any aspect of the tax
position, the tax position is no longer considered effectively
settled and the entity shall reevaluate the tax position in
accordance with the requirements of this Subtopic for tax
positions.
40-4
Paragraph 740-10-25-15 requires that a change in judgment that
results in derecognition of a tax position taken in a prior
annual period (including any related interest and penalties)
shall be recognized as a discrete item in the period in which
the change occurs. Paragraph 740-270-35-6 addresses the
different accounting required for such changes in a prior
interim period within the same fiscal year.
Management’s assessment of UTBs is an ongoing process. ASC 740-10-25-14, ASC 740-10-35-2,
and ASC 740-10-40-2 stipulate that management, when considering the subsequent
recognition and measurement of the tax benefit associated with a tax position that did
not initially meet the recognition threshold and the subsequent derecognition of one
that did, should base such assessments on its “best judgment given the facts,
circumstances, and information available at the reporting date.”
ASC 740-10-25-8 states, in part:
If the more-likely-than-not recognition threshold is
not met in the period for which a tax position is taken or expected to be taken, an
entity shall recognize the benefit of the tax position in the first interim period
that meets any one of the following conditions:
- The more-likely-than-not recognition threshold is met by the reporting date.
- The tax position is effectively settled through examination, negotiation or litigation.
- The statute of limitations for the relevant taxing authority to examine and challenge the tax position has expired.
An entity that has taken a tax position that previously did not meet the
more-likely-than-not recognition threshold can subsequently recognize the benefit
associated with that tax position only if new information changes the technical merits
of the position or the tax position is effectively settled through examination or
expiration of the statute of limitations.
The finality or certainty of a tax position’s outcome through settlement or expiration of
the statute of limitations is not required for the subsequent recognition,
derecognition, or measurement of the benefit associated with a tax position. However,
such changes in judgment should be based on management’s assessment of new information
only, not on a new evaluation or interpretation of previously available information.
See Section 11.4 for a discussion of subsequent
changes in recognition and measurement of uncertainty in income taxes in a business
combination.
4.5.1 Decision Tree for the Subsequent Recognition, Derecognition, and Measurement of Benefits of a Tax Position
4.5.2 New Information
New information may result in a change to the recognition or
measurement of a tax position. New information may also include, but is not limited
to, information obtained from a recently completed examination by the tax authority
of a tax year that includes a similar type of tax position, developments in case
law, changes in tax law and regulations, and rulings by the tax authority.
An entity that has taken a tax position that previously did not meet the
more-likely-than-not recognition threshold can subsequently recognize a benefit
associated with the tax position if new information changes the technical merits of
the position. The examination of a tax year by the relevant authority in a
jurisdiction (e.g., the IRS in the United States) does not mean that all tax
positions not disputed by the tax authority meet the more-likely-than-not
recognition threshold. An entity cannot assert that a tax position can be sustained
on the basis of its technical merits simply because the tax authority did not
dispute or disallow the position. This lack of dispute or disallowance may be
because the tax authority is overlooking a position.
An entity that has taken a tax position that previously met the
more-likely-than-not recognition threshold can subsequently remeasure the benefit
associated with the tax position on the basis of new information, without the
limitation that the new information must change the technical merits of the
position.
Under ASC 740, an entity should not consider new information that is received after
the balance sheet date, but that is not available as of the balance sheet date, when
evaluating an uncertain tax position as of the balance sheet date. Specifically, paragraph B38 in the Basis for Conclusions of Interpretation 48 (not codified in ASC
740), states:
In deliberating changes in judgment in this Interpretation, the
Board decided that recognition and measurement should be based on all
information available at the reporting date and that a subsequent change in
facts and circumstances should be recognized in the period in which the change
occurs. Accordingly, a change in facts subsequent to the reporting date but
prior to the issuance of the financial statements should be recognized in the
period in which the change in facts occurs.
Note that subsequent events are currently accounted for under ASC 855. The guidance
in ASC 740 applies only to situations covered by ASC 740 and is not analogous to
other situations covered by ASC 855. ASC 855 prescribes the accounting requirements
for two types of subsequent events: (1) recognized subsequent events, which
constitute additional evidence of conditions that existed as of the balance sheet
date and for which adjustment of previously unissued financial statements is
required, and (2) nonrecognized subsequent events, which constitute evidence of
conditions that did not exist as of the balance sheet date but arose after that date
and for which only disclosure is required.
The examples below illustrate the consideration of new information
concerning an uncertain tax position that is received after the balance sheet
date.
Example 4-5
As of the balance sheet date, an entity
believes that it is more likely than not that an uncertain
tax position will be sustained. Before the financial
statements are issued or are available to be issued,
management becomes aware of a recent court ruling that
occurred after the balance sheet date and that disallowed a
similar tax position taken by another taxpayer. Because the
court ruling occurred after the balance sheet date, the
entity should reflect any change in its assessment of
recognition and measurement that resulted from the new
information in the interim period that includes the court
ruling; however, the entity should consider whether the
court ruling and an estimate of its impact should be
disclosed in accordance with ASC 855.
Example 4-6
Assume that (1) an entity finalizes a tax litigation
settlement with the tax authority after the balance sheet
date but before its financial statements are issued or are
available to be issued and (2) the events that gave rise to
the litigation had taken place before the balance sheet
date. According to ASC 740, the entity should not adjust its
financial statements to reflect the subsequent settlement;
however, the entity should disclose, in the notes to the
financial statements, the settlement and its effect on the
financial statements.
4.5.3 Effectively Settled Tax Positions
A tax position that was included in an examination by the tax authority can be
considered effectively settled without being legally extinguished. An entity must
use significant judgment in determining whether a tax position is effectively
settled.
A tax position is considered effectively settled when both the entity and the tax
authority believe that the examination is complete and that the likelihood of the
tax authority’s reexamining the tax position is remote (as defined in ASC 450).
Although a tax position can be considered effectively settled only if it was part of
a completed examination, a tax position that is part of an examination does not need
to be specifically reviewed by the tax authority to be considered effectively
settled; however, the fact that an issue was not examined will affect the assessment
of whether examination or reexamination is remote.
For a tax position to be considered effectively settled, it must meet all of the
following conditions in ASC 740-10-25-10:
- The taxing authority has completed its examination procedures including all appeals and administrative reviews that the taxing authority is required and expected to perform for the tax position.
- The entity does not intend to appeal or litigate any aspect of the tax position included in the completed examination.
- It is remote that the taxing authority would examine or reexamine any aspect of the tax position. In making this assessment management shall consider the taxing authority’s policy on reopening closed examinations and the specific facts and circumstances of the tax position. Management shall presume the relevant taxing authority has full knowledge of all relevant information in making the assessment on whether the taxing authority would reopen a previously closed examination.
If the tax authority has specifically examined a tax position during the examination
process, an entity should consider this information in assessing the likelihood that
the tax authority would reexamine the tax position included in the completed
examination. Effective settlement of a position subject to an examination does not
result in effective settlement of similar or identical tax positions in periods that
have not been examined.
Accordingly, an entity must first determine whether the tax authority has completed
its examination procedures, including all appeals and administrative reviews that
are required and are expected to be performed for the tax position. For U.S. federal
income tax positions, we believe that the condition that all administrative reviews
be complete includes reviews by the Joint Committee on Taxation for cases that are
subject to the committee’s approval. A completed tax examination may be related only
to specific tax positions or to an entire tax year. While it is common for all tax
positions for a particular tax year to be effectively settled at the same time,
there may be circumstances in which individual tax positions are effectively settled
at different times.
The entity must then determine whether it intends to appeal or litigate any aspect of
the tax position associated with the completed examination. If the entity does not
intend to appeal or litigate, it must determine whether the tax authority’s
subsequent examination or reexamination of any aspect of the tax position is
remote.
In determining whether to reopen a closed examination, tax authorities follow
policies that vary depending on the type of examination and the agreement entered
into between the taxpayer and the tax authority. For example, a tax authority may be
permitted to reexamine a previously examined tax position (or all tax positions that
were part of a closed examination) only if specific conditions exist, such as fraud
or misrepresentation of material fact. An entity must base the likelihood that the
tax authority would examine or reexamine a tax position on individual facts and
circumstances, assuming that the tax authority has all relevant information
available to it. The entity may need to use significant judgment to evaluate whether
individual tax positions included in the completed examination meet the conditions
of a tax authority’s policy not to examine or reexamine a tax position. If the
likelihood is considered remote and the other conditions are met, the tax position
is effectively settled and the entity recognizes the full benefit associated with
that tax position.
Given the complexities in the determination of whether a tax position has been
effectively settled, consultation with income tax accounting advisers is
encouraged.
A tax position that is determined to be effectively settled must be reevaluated if
(1) an entity becomes aware that the tax authority may examine or reexamine that
position or (2) the entity changes its intent to litigate or appeal the tax
position. In addition, an entity may obtain information in an examination that leads
it to change its evaluation of the technical merits.
ASC 740-10-25-12 acknowledges that “[a]n entity may obtain
information during the examination process that enables that entity to change its
assessment of the technical merits of a tax position or of similar tax positions
taken in other periods.” However, an entity’s conclusion that a position is
“effectively settled,” as described in ASC 740-10-25-8, is not a basis for changing
its assessment of the technical merits of that or a similar tax position.
See Section 7.3.3 for a discussion related to the interim
accounting for subsequent change in recognition and measurement.
4.6 Other Topics
4.6.1 Accounting for the Tax Effects of Tax Positions Expected to Be Taken in an Amended Tax Return or Refund Claim or to Be Self-Reported Upon Examination
In certain jurisdictions, an entity may elect to take a certain tax
position on its original tax return but subsequently decide to take an alternative
tax position (which is also acceptable) in an amended return. For example, an entity
may amend a previously filed income tax return to retroactively elect a deduction
for foreign taxes paid rather than to claim a credit or vice versa, or to file a
refund claim to carry back a tax operating loss or tax credit to a prior year.
Alternatively, an entity under examination may present to the examiner
self-identified adjustments (i.e., affirmative adjustments) to change the amount of
income, deductions, or credits reflected in the previously filed tax return that is
under examination.2
The decision to file an amended tax return or refund claim or to self-report a tax
position upon examination may be made before the end of the reporting period even
though the process of actually preparing the amended tax return/refund claim, or
self-reporting the tax position, might not occur until after the reporting period
ends.
An entity should account for the tax effects of its intent to file amended tax
returns or refund claims or to report self-identified audit adjustments (i.e.,
affirmative adjustments) in its financial statements by using the guidance in ASC
740-10. ASC 740-10-05-6 states, in part:
This Subtopic 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. [Emphasis added]
In addition, ASC 740-10-25-2 states:
Other than the exceptions identified in the
following paragraph, the following basic requirements are applied in accounting
for income taxes at the date of the financial statements:
- A tax liability or asset shall be recognized based on the provisions of this Subtopic applicable to tax positions, in paragraphs 740-10-25-5 through 25-17, for the estimated taxes payable or refundable on tax returns for the current and prior years.
- A deferred tax liability or asset shall be recognized for the estimated future tax effects attributable to temporary differences and carryforwards.
While an amended return or refund claim may be filed after the reporting period has
ended, an entity should account for the tax effects in the period in which it
concludes that it expects to amend the return or file the refund claim. Such
accounting should be consistent with the general recognition and measurement
principles of ASC 740-10. An entity should determine its intent with respect to the
filing of an amended return or refund claim as of each reporting date. Changes in
intent with respect to the filing of an amended return or refund claim should be
supported by a change in facts or circumstances.
In a manner consistent with the above discussion, refund claims that an entity
intends to file in connection with the carryback of tax attributes (e.g., an NOL or
a tax credit) should generally be reflected as an income tax receivable (after the
entity considers the recognition and measurement principles of ASC 740-10) in the
reporting period in which the entity concludes that it will file the refund
claim.
Affirmative adjustments should be accounted for similarly to tax positions that will
be taken on a tax return (i.e., similarly to an amended return or refund claim).
That is, the entity should account for the tax positions associated with affirmative
adjustments in the period in which the entity concludes that it intends to present
the positions to an examiner in a future tax examination. Generally, we would expect
this to be the period in which the position was originally taken. Such accounting
should be consistent with the general recognition and measurement principles of ASC
740-10.
Note that this section does not address the additional
considerations that can arise when the filing of the amended tax return or refund
claim, or the decision to self-report a tax position, represents the correction of
an error. See Section 12.6.1 for guidance on
those considerations.
4.6.2 State Tax Positions
Certain operational activities may be taxable in multiple jurisdictions (e.g.,
federal and state) or may need to be allocated between these jurisdictions on the
basis of the application of tax rules (e.g., domestic versus international
authorities, state versus state authorities). It is not always certain how these
rules should be applied and therefore, management routinely makes judgments about
the application of various technical rules (e.g., regarding the jurisdictions in
which to report tax positions and how to allocate revenue and expenses among these
jurisdictions). In addition to being subject to federal income taxes, an entity
could also be subject to income tax imposed by a state or states. While there are
similarities between the federal and state income tax rules, there are also
differences that give rise to unique state tax positions.
4.6.2.1 Economic Nexus
“Economic nexus” refers to a view, held by some states, that a
company deriving income from the residents of a state should be taxable even
when the connection with the state is not physical (i.e., its only contact with
the state is economic). Many states have enacted tax laws that could subject an
out-of-state entity to income taxes in that state in accordance with the
economic nexus theory even when the entity has no physical presence in that
state.
An entity should consult all relevant law and authorities to
determine whether, for a state in which it does not file income tax returns, it
is more likely than not that it does not have a filing obligation in that state.
While the concept of economic nexus may sometimes be ambiguous and difficult to
apply, the entity must, to comply with the requirements of ASC 740, assess the
technical merits of its conclusion that it does not have economic nexus in a
state. An entity should consider engaging specialists for assistance in
performing this assessment.
An entity that concludes that it is more likely than not that it
does not have economic nexus in a particular state has met the recognition
threshold for this tax position. Conversely, an entity that has a reasonable
basis for not filing a state income tax return in a particular state but has
concluded that it is more likely than not that it has economic nexus in that
state has not met the recognition threshold.
Under ASC 740, if a tax position does not meet the recognition
threshold, a liability is recognized for the total amount of the tax benefit of
that tax position (see Section 4.2). That liability should not be subsequently
derecognized unless there is a change in technical merits, the position is
effectively settled, or the statute of limitations expires. In many
jurisdictions, it is common for the statute of limitations to begin to run only
when a tax return is filed. Therefore, when an entity does not file a state
income tax return in such a jurisdiction, the entity cannot consider the statute
of limitations in determining whether it has a filing obligation and UTB
liability in that state.
Some state tax authorities may have a widely understood
administrative practice or precedent under which the authority would, in the
event of an examination and in the absence of a voluntary disclosure agreement,
look back no more than a certain number of years to determine the amount of
income tax deficiency due (i.e., a “lookback period”). If a state tax authority
has such a practice, the entity should consider it when calculating the
liability for UTBs that meet certain conditions.
In the absence of a widely understood administrative practice or
precedent, however, ASC 740 requires accrual of the state income tax liability
for every year in which it is more likely than not that the entity had economic
nexus with that state, and the state tax liability is determined as if state
income tax returns were prepared in accordance with ASC 740’s recognition and
measurement guidance. Interest and penalties would be accrued under ASC 740 and
on the basis of the relevant tax law. Such liabilities for UTBs would be
derecognized only when (1) a change in available information indicates that the
technical merits of the position subsequently meet the more-likely-than-not
recognition threshold or (2) the position is effectively settled.
For example, assume that an entity has not filed state income
tax returns in a particular state and is aware of a widely understood
administrative practice under which only entities that have not historically
filed tax returns with that state must file six years of tax returns.
Accordingly, at the end of each year, the entity is permitted to record a
liability for UTBs for the amount of tax due to the state for the most recent
six years as if tax returns, prepared in accordance with ASC 740’s recognition
and measurement, were filed for the most recent six years. Interest and
penalties would be accrued on such deficiencies as required by ASC 740 and on
the basis of the relevant tax law.
An entity should be able to demonstrate that it has considered
all relevant facts and circumstances in reaching its conclusion about the
maximum number of previous years that the state tax authority will require the
entity to file under its widely understood administrative practices or
precedents. The number of such previous years should not change unless new
information becomes available. This guidance applies only to economic nexus when
a statute of limitations does not expire because an income tax return has not
been filed; it should not necessarily be applied to other situations.
An entity may also consider entering into a state’s voluntary
disclosure program, which may limit the number of prior years for which tax
returns will be required. The terms and conditions of such programs vary among
states; generally, however, voluntary disclosure programs limit lookback periods
to three or four years. In addition, when assessing its UTB liabilities, an
entity should generally not consider the potential to limit the lookback period
until the reporting period in which it enters the particular state’s voluntary
disclosure program.3 Therefore, when the entity has entered into such a program, its liability
for UTBs for that state’s income taxes would be limited by the number of prior
years for which tax returns will be required under the terms and conditions of
the program, plus accrued interest and penalties, if applicable. Entities should
consult their tax advisers regarding the effect of entering into a state’s
voluntary disclosure program.
4.6.2.2 Due Process
In addition to considering the application of relevant tax rules
in accounting for state tax positions, an entity should also consider the “due
process clause” and the “commerce clause” of the U.S. Constitution, which limit
the states’ rights to tax.
The due process clause of the Fourteenth Amendment requires a
definite link between a state and the person, property, or transaction it seeks
to tax; the connection need not include physical presence in the state. This
clause also requires that the income attributed to the state for tax purposes be
rationally related to values connected with the taxing state. The commerce
clause of the Constitution gives Congress the authority to regulate commerce
among the states.
No state or federal law is allowed to violate the Constitution.
In evaluating all tax positions for recognition under ASC 740, as well as for
technical merits under the tax law as written and enacted, an entity may need to
assess whether the U.S. Supreme Court would overturn that tax law. This analysis
is required for recognition even though the court issues certiorari for tax
matters involving the constitutionality of state income taxes only in rare
circumstances. Generally, an entity will conclude that the court would uphold
the tax law. However, in certain situations, an entity may conclude that the
applicable tax law violates the Constitution.
For example, with respect to economic nexus, an entity may
determine that, under the tax law, it is more likely than not that it has
incurred a tax obligation to the tax authority. However, the entity may also
conclude that the same tax law more likely than not violates the Constitution.
In other words, if the entity were to litigate this position to the U.S. Supreme
Court, it is more likely than not that the court, after evaluating such a law,
would deem that law unconstitutional; in such a situation, the entity would
therefore not have a tax obligation to the tax authority.
An entity must have sufficient evidence to support its
conclusion about the constitutionality of the current tax law. This evidence
will often be in the form of a legal opinion from competent outside counsel. The
legal opinion would state whether the tax law violates the Constitution and
whether it is more likely than not that the U.S. Supreme Court would overturn
the enacted tax law.
4.6.3 Uncertain Tax Positions in Transfer Pricing Arrangements
Transfer pricing relates to the pricing of intra-entity and related-party
transactions involving transfers of tangible property, intangible property,
services, or financing between affiliated entities. These transactions include
transfers between domestic or international entities, such as (1) U.S. to foreign,
(2) foreign to foreign, (3) U.S. to U.S., and (4) U.S. state to state.
The general transfer pricing principle is that the pricing of a related-party
transaction should be consistent with the pricing of similar transactions between
independent entities under similar circumstances (i.e., an arm’s-length
transaction). Transfer pricing tax regulations are intended to prevent entities from
using intra-entity charges to evade taxes by inflating or deflating the profits of a
particular jurisdiction the larger consolidated group does business in. Even if a
parent corporation or its subsidiaries are in tax jurisdictions with similar tax
rates, an entity may have tax positions that are subject to the recognition and
measurement principles in ASC 740-10-25-6 and ASC 740-10-30-7.
An entity’s exposure to transfer pricing primarily occurs when the entity includes in
its tax return the benefit received from a related-party transaction that was not
conducted as though it was at arm’s length. A UTB results when one of the related
parties reports either lower revenue or higher costs than it can sustain (depending
on the type of transaction). While a benefit is generally more likely than not to
result from such a transaction (e.g., some amount will be allowed as an interest
deduction, royalty expense, or cost of goods sold), the amount of benefit is often
uncertain because of the subjectivity of valuing the related-party transaction.
An entity must apply the two-step process (i.e., recognition and measurement) under
ASC 740-10 to all uncertain tax positions within its scope. The requirements of ASC
740 in the context of transfer pricing arrangements, including related
considerations and examples, are outlined below.
4.6.3.1 Determination of the Unit of Account
Before applying the recognition and measurement criteria, an entity must identify
all material uncertain tax positions and determine the appropriate unit of
account for assessment. Intra-entity and related-party transactions under
transfer pricing arrangements are within the scope of ASC 740 since they
encompass “[a]n allocation or a shift of income between jurisdictions.”
Further, tax positions related to transfer pricing generally should be evaluated
individually, since two entities and two tax jurisdictions are involved in each
transaction. Such an evaluation should be performed even when the transaction is
supported by a transfer pricing study prepared by one of the entities.
Typically, there would be at least two units of account. For example, the price
at which one entity will sell goods to another entity will ultimately be the
basis the second entity will use to determine its cost of goods sold. In
addition, some transfer pricing arrangements could be made up of multiple
components that could be challenged individually or in aggregate by a taxing
authority. Therefore, there could be multiple of units of account associated
with a particular transfer pricing arrangement. See Section 4.1.2.2 for more information about determining the unit
of account.
4.6.3.2 Recognition
ASC 740-10-25-6 indicates that the threshold for recognition has
been met “when it is more likely than not, based on the technical merits, that
the position will be sustained upon examination.” An entity should apply the
recognition threshold and guidance in ASC 740 to each unit of account in a
transfer pricing arrangement. In some cases, a tax position will be determined
to have met the recognition threshold if a transaction has taken place to
generate the tax positions and some level of benefit will therefore be
sustained. For example, assume that a U.S. parent entity receives a royalty for
the use of intangibles by a foreign subsidiary that results in taxable income
for the parent and a tax deduction for the foreign subsidiary. The initial tax
filing (income in the receiving jurisdiction and expense/deduction in the paying
jurisdiction) may typically meet the more-likely-than-not recognition threshold
on the basis of its technical merits, since a transaction between two parties
has occurred. However, because there are two entities and two tax jurisdictions
involved, the tax jurisdictions could question whether the income is sufficient,
whether the deduction is excessive, or both.
4.6.3.3 Measurement
After an entity has assessed the recognition criteria in ASC 740 and has
concluded that it is more likely than not that the tax position taken will be
sustained upon examination, the entity should measure the associated tax
benefit. This measurement should take into account all relevant information,
including tax treaties and arrangements between tax authorities. As discussed
above, each tax position should be assessed individually and a minimum of two
tax positions should be assessed for recognition and measurement in each
transfer pricing transaction.
For measurement purposes, ASC 740-10-30-7 requires that the tax benefit be based
on the amount that is more than 50 percent likely to be realized upon settlement
with a tax jurisdiction “that has full knowledge of all relevant information.”
Intra-entity or transfer pricing assessments present some unique
measurement-related challenges that are based on the existence of tax treaties
or other arrangements (or the lack of such arrangements) between two tax
jurisdictions.
Measurement of uncertain tax positions is typically based on facts and
circumstances. The following are some general considerations (not all-inclusive):
- Transfer pricing studies — An entity will often conduct a
transfer pricing study with the objective of documenting the appropriate
arm’s-length pricing for the transactions. The entity should consider
the following when using a transfer pricing study to support the tax
positions taken:
- The qualifications and independence of third-party specialists involved (if any).
- The type of study performed (e.g., benchmarking analysis, limited or specified-method analysis, U.S. documentation report, Organisation for Economic Co-operation and Development report) and, to avoid incurring penalties, whether it satisfies the particular jurisdiction’s requirements.
- The specific transactions and tax jurisdictions covered in the study.
- The period covered by the study.
- The reasonableness of the model(s) and the underlying assumptions used in the study (i.e., comparability of companies or transactions used, risks borne, any adjustments made to input data).
- Any changes in the current environment, including new tax laws in effect.
- Historical experience — An entity should consider previous settlement outcomes of similar tax positions in the same tax jurisdictions. Information about similar tax positions, in the same tax jurisdictions, that the entity has settled in previous years may serve as a good indicator of the expected settlement of current positions.
- Applicability of tax treaties or other arrangements — An entity should consider whether a tax treaty applies to a particular tax position and, if so, how the treaty would affect the negotiation and settlement with the tax authorities involved.
- Symmetry of positions — Even though each tax position should be evaluated individually for appropriate measurement, if there is a high likelihood of settlement through “competent-authority” procedures under the tax treaty or other agreement, an entity should generally use the same assumptions about such a settlement to measure both positions (i.e., the measurement assumptions are similar, but the positions are not offset). Under the terms of certain tax treaties entered into by the United States and foreign jurisdictions, countries mutually agree to competent-authority procedures to relieve such companies of double taxation created by transfer pricing adjustments to previously filed returns. If competent-authority procedures are available, entities should carefully consider whether to pursue relief through them and whether the particular jurisdictions involved are highly likely to reach an agreement with respect to the particular disputed transactions.
An entity should carefully consider whether the tax
jurisdictions involved strictly apply the arm’s-length principle. Some
jurisdictions may have a mandated statutory margin that may or may not equate to
what is considered arm’s length by another reciprocal taxing jurisdiction. In
these situations, when an entity measures positions, it may be inappropriate for
the entity to assume that they are symmetrical.
The example below illustrates the above considerations. See
Section 13.2.4
for a discussion of balance sheet presentation in transfer pricing arrangements
under ASC 740.
Example 4-7
Assume that a U.S. entity licenses its name to its
foreign subsidiary in exchange for a 2 percent royalty
on sales. This example focuses on the two separate tax
positions that the entity has identified in connection
with the royalty transaction. For tax purposes, the U.S.
entity recognizes royalty income in its U.S. tax return
and the foreign subsidiary takes a tax deduction for the
royalty expense in its local-country tax return. Both
positions are deemed uncertain, since the respective tax
authorities may either disallow a portion of the
deduction (deeming it to be excessive) or challenge the
royalty rate used in this intra-entity transaction
(deeming it to be insufficient). The entity should
evaluate both tax positions under the recognition and
measurement criteria of ASC 740. In this example, the
“more-likely-than-not” recognition threshold is
considered met since a transaction has occurred between
the two parties and it is therefore more likely than not
that the U.S. entity has income and the foreign
subsidiary has a deduction.
The U.S. entity believes that if the IRS
examines the tax position, it will more likely than not
conclude that the royalty rate should have been higher
to be in line with an arm’s-length transaction. In the
absence of any consideration of relief through an
international tax treaty, the lowest royalty rate that
the entity believes is more than 50 percent likely to be
accepted by the IRS is 5 percent, on the basis of
historical experience and recent transfer pricing
studies. A higher royalty rate would not only trigger an
increase in taxable income for the U.S. entity but would
also result in double taxation of the additional royalty
for the amount that is in excess of the deduction
claimed by the foreign subsidiary (i.e., 3 percent in
this instance — calculated as the 5 percent estimated
arm’s-length amount less the original 2 percent recorded
in the transaction). If there is a tax treaty between
the United States and the relevant foreign tax
jurisdiction, that treaty will typically include
procedures that provide for competent-authority relief
from double taxation. Under such an agreement, the two
tax authorities may agree at their discretion on an
acceptable royalty rate in each jurisdiction. One tax
authority would make an adjustment (i.e., increasing
revenue and taxable income) that would require a
consistent transfer pricing adjustment (i.e., increasing
deduction and reducing taxable income) in the related
party’s tax jurisdiction.
In this example, management determines
that it would pursue the competent-authority relief.
Accordingly, it concludes that it is appropriate to
recognize relief from double taxation because of the
expected outcome of competent-authority procedures.
Also, management has represented that the entity will
incur the cost of pursuing a competent-authority
process. Therefore, the U.S. entity records a liability
that would result from resolution of the double taxation
of this non-arm’s-length transaction if the original 2
percent royalty rate is increased through application of
the competent-authority process. Management of the U.S.
entity believes that a royalty rate of 3.5 percent is
the lowest percentage (i.e., greatest benefit) that is
more than 50 percent likely to be accepted by the two
tax jurisdictions under such a treaty on the basis of
its historical experience. Because there is a high
likelihood of settlement through the competent-authority
process, the foreign subsidiary should also use this
assumption when measuring the tax position to ensure
symmetry of the two tax positions under ASC 740. Note
that this example focuses on one tax position in each
jurisdiction; there may be other tax positions related
to this transfer pricing arrangement that would have to
be similarly analyzed.
4.6.4 Uncertainty in Deduction Timing
A deduction taken on an entity’s tax return may be certain except for the appropriate
timing of the deduction under the tax law in the applicable jurisdiction. In such
cases, the recognition threshold is satisfied and the entity should consider the
uncertainty in the appropriate timing of the deduction in measuring the associated
tax benefit in each period.
Example 4-8
Assume the following:
- An entity purchases equipment for $1,000 in 20X7.
- The entity’s earnings before interest, depreciation, and taxes are $1,200 each year in years 20X7–20Y1.
- For book purposes, the equipment is depreciated ratably over five years
- For tax purposes, the entity deducts the entire $1,000 in its 20X7 tax return.
- The entity has a 25 percent tax rate and is taxable in only one jurisdiction.
- There is no half-year depreciation rule for accounting or tax purposes.
- For simplicity, interest and penalties on tax deficiencies are ignored.
In applying the recognition provisions of ASC 740-10-25-5,
the entity has concluded that it is certain that the $1,000
equipment acquisition cost is ultimately deductible under
the tax law. Thus, the tax deduction of the tax basis of the
acquired asset would satisfy the recognition threshold in
ASC 740-10-25-6. In measuring the benefit associated with
the deduction, the entity concludes that the largest amount
that is more than 50 percent likely to be realized in a
negotiated settlement with the tax authority is $200 per
year for five years (the tax life is the same as the book
life).
Exclusive of interest and penalties, the entity’s
current-year tax benefit is unaffected because the
difference between the benefit taken in the tax return and
the benefit recognized in the financial statements is a
temporary difference.
However, although interest and penalties are ignored in this
example for simplicity, ASC 740-10-25-56 requires an entity
to recognize interest and penalties on the basis of the
provisions of the relevant tax law. In this case, the entity
would begin accruing interest in 20X8. Therefore, even
though this is a timing difference, the accrual of interest
(and penalties, if applicable) will have an impact on profit
and loss (P&L).
The 20X7 tax return reflects a $250
reduction in the current tax liability for the $1,000
deduction claimed. For book purposes, the entity will
recognize a balance sheet credit of $200, or ($1,000 – $200)
× 25%, for UTBs associated with the deduction claimed in
year 1. The liability for UTBs will be extinguished over the
succeeding four years at $50 ($200 × 25 percent) per year.
The entity would record the following journal entries,
excluding interest and penalties, for the tax effects of the
purchased equipment:
See Section 3.3.5 for a discussion related to the accounting for
tax method changes.
4.6.5 Deferred Tax Consequences of UTBs
Recording a liability for a UTB may result in a corresponding
temporary difference and DTA. The examples below illustrate how a DTA can arise from
the accounting for a UTB.
Example 4-9
Company A has taken an uncertain tax position in State B that
reduces its taxes payable by $10,000 in that state. In
assessing the uncertain tax position under ASC 740, A
determines that it is not more likely than not that the
position, on the basis of its technical merits, will be
sustained upon examination. Therefore, A records a $10,000
liability for the UTB.
Company A will receive an additional federal tax deduction if
it is ultimately required to make an additional tax payment
to the state. Therefore, A should record a DTA for the
indirect benefit from the potential disallowance of the
uncertain tax position taken on its tax return in State
B.
If the federal tax rate is 25 percent, A
would record the following journal entries to account for
the uncertain tax position and the indirect tax benefit:
Like other DTAs, the DTA created as a result of recording the
liability for the UTB should be evaluated for
realizability.
Example 4-10
Company A begins operations in State B but
does not file a tax return in that state. ASC 740-10-20
indicates that the “decision not to file a tax return” is a
tax position. In assessing the tax position under ASC 740, A
determines that it may have nexus in B and that it is not
more likely than not that the position, on the basis of its
technical merits, will be sustained upon examination.
Therefore, A records a $10,000 liability for the taxes
payable to B for the current year.
However, if A were to file a return in B, it would also have
a large deductible temporary difference that would result in
an $8,000 DTA in that state. Therefore, A should record a
DTA as a result of potential nexus in B and evaluate it for
realizability.
If the federal tax rate is 21 percent, A
would record the following journal entries to account for
the uncertain tax position and the related temporary
difference:
See Section 14.4.1.7 for further
discussion of the presentation of deferred taxes resulting
from UTBs.
4.6.6 UTBs and Spin-Off Transactions
In a spin-off transaction, a reporting entity (the “spinnor”) may
distribute one or more of its subsidiaries (“spinnees”) to its shareholders in the
form of a dividend. After the spin-off is finalized, complexities can arise in the
accounting for uncertain tax positions in the separate financial statements of the
spinnor and spinnee when, before a spin-off, they file a consolidated tax return as
a “consolidated return group.” Under U.S. federal tax law, members of a consolidated
return group are severally liable for all tax positions taken in the consolidated
return. The taxing authority typically seeks collection of the payment of the
consolidated return group’s tax liabilities from the parent of the consolidated
return group; however, if the IRS cannot collect from the parent of the consolidated
return group (e.g., the parent is insolvent), the IRS can seek payment from a
subsidiary of the consolidated return group. The example below illustrates the
accounting for UTBs in a spin-off transaction.
Example 4-11
Company A, in the current reporting period,
spins off a portion of its business that was conducted by
Company B. Before the spin-off, A and B were in the same
federal consolidated return group and (1) A had recognized a
liability for uncertain tax positions in its consolidated
financial statements associated with B’s operations and (2)
B had recognized the liability in its stand-alone financial
statements prepared under the separate-return approach (see
Section 8.3.1.1). Under the applicable tax
law, A is the primary obligor of the liability, although B
is a secondary obligor in the event that the taxing
authorities are unable to collect from A. In accordance with
the terms of the separation agreement, A will be responsible
for funding the settlement of the uncertain tax positions in
tax returns for periods before the spin-off. Company A is
solvent as of the date of the spin-off and is expected to
remain so afterward.
Company A
Upon completion of the spin-off transaction,
A should continue to recognize a liability associated with
the uncertain tax position. Because the uncertain tax
position was taken in a consolidated return group filed by
A, the primary obligor under the tax law was and will
continue to be A. Accordingly, A should continue to
recognize the liability for the UTB associated with the
uncertain tax position under ASC 740.
Company B
Each of the following views is acceptable:
-
View A — Because A is the primary obligor, B cannot be the primary obligor and therefore should not continue to recognize the liability for the UTB. In accordance with the tax law, the liability is retained by A, and B is typically liable only if A becomes insolvent. Accordingly, B no longer has an uncertain tax position under ASC 740 and would remove the liability with an offsetting credit to capital at the time of the spin-off. Company B would separately assess its contingent liability to the tax authority if A becomes insolvent under ASC 450.This view is consistent with the guidance in ASC 405-40 on obligations resulting from joint and several liability obligations, which can be applied by analogy even though income taxes are not within its scope. ASC 405-40-30-1 states:Obligations resulting from joint and several liability arrangements included in the scope of this Subtopic initially shall be measured as the sum of the following:
- The amount the reporting entity agreed to pay on the basis of its arrangement among its co-obligors
- Any additional amount the reporting entity expects to pay on behalf of its co-obligors. If some amount within a range of the additional amount the reporting entity expects to pay is a better estimate than any other amount within the range, that amount shall be the additional amount included in the measurement of the obligation. If no amount within the range is a better estimate than any other amount, then the minimum amount in the range shall be the additional amount included in the measurement of the obligation.
- View B — Because B is still an obligor under the tax law, it should continue to record a liability for the UTB under ASC 740. The uncertain tax position was generated by B and presented in its separate company financial statements before the spin-off. In addition, although A insulates B from liability to a degree, B could be required to settle the uncertain tax position. Accordingly, B should apply ASC 740 in recording and subsequently measuring an uncertain tax benefit. Company B would also record an indemnification receivable, subject to (1) any contractual limitations on its amount and (2) management’s assessment of the collectibility of the indemnification asset (by analogy to the guidance in ASC 805-20-35-4), reflecting the fact that A has agreed to be responsible for settlement of the uncertain tax positions.
See Section
11.3.6.5 for additional guidance on indemnification agreements.
Footnotes
2
Presenting affirmative adjustments upon examination, rather
than claiming the position on an originally filed income tax return, might
be part of the entity’s strategy to avoid penalties on a particular tax
position in a particular tax jurisdiction or to limit the jurisdiction’s
ability to make other changes to the year (i.e., changes that are unrelated
to the adjustment being sought by the entity).
3
Some states require an entity to be accepted into the voluntary
disclosure program before being afforded audit protection for previous
years.