When recognizing benefits from uncertain tax positions in their financial statements, what level of confidence should corporations have that those positions will be sustained? How do they determine whether or not their positions meet that threshold for recognition?And if the position meets that recognition threshold, what share of the related benefit should be included in the entity's financial statements? What actions or events could change that recognition status for future financial statements?

To address such questions, the Financial Accounting Standards Board recently issued an exposure draft of "Accounting for Uncertain Tax Positions," an interpretation of Statement No. 109, Accounting for Income Taxes. The proposed interpretation is intended to provide clearer standards for assessing and recognizing such positions and a more uniform basis for evaluating tax-related information presented in financial statements. The interpretation encompasses all tax positions to which adjustments are not barred under relevant statutes of limitations.

If approved, the interpretation would be effective for any taxpayer whose fiscal year ends after Dec. 15, 2005.

The need for clarification

For financial statement tax reporting purposes, companies have applied varying standards for addressing uncertain tax positions, with some companies taking tax benefits for positions that only had a one-in-three chance of being sustained in a challenge by the Internal Revenue Service or other tax authority.

Existing FASB guidance -- or the lack thereof -- offers considerable latitude for interpretation among individual companies, and diverse accounting practices have developed for recognizing those tax positions in financial statements. Such practices lead to inconsistencies in the criteria used to recognize, de-recognize or measure benefits related to uncertain tax positions. As a result, it becomes more difficult to evaluate the validity of recognized tax benefits and liabilities, and to compare tax-related reporting from one financial statement to another.

The interpretation establishes a higher, but more uniform, threshold that companies must meet for recognizing the benefits of a tax position on their financial statements. Meeting that threshold first requires assessing whether or not the tax position merits recognition, and then determining what portion of that claimed benefit should be recognized in the financial statements. The interpretation also provides guidance for deciding when a position taken in previous financial statements no longer meets the recognition threshold, and must therefore be de-recognized.

Recognition threshold

Companies wishing to initially recognize a tax position in their financial statements would need to have a probable level of confidence (70 percent to 80 percent) of being sustained in a challenge by the IRS or other tax authority, based solely on the technical merits of the position they have taken.

The interpretation lists the following factors as supportive evidence for such recognition:

* Unambiguous tax law supporting that position;

* An unqualified "should prevail" tax opinion provided by a qualified expert for which all conditions are objectively verifiable;

* Similar positions in past tax returns that were obviously presented and either accepted or not disallowed or challenged during an examination by taxing authorities; and,

* Legal precedent for similar positions taken by other taxpayers that have been favorably resolved through litigation with taxing authorities.

The proposed interpretation exposure draft offers the example of an enterprise seeking a deduction of $1 million for contributing an intangible asset to an unrelated tax-exempt entity. The corporation cites clear and unambiguous tax law supporting its position that its contribution is a valid deduction.

The company also has a history of claiming deductions for similar contributions, and while the total value claimed in the past was not allowed, the deduction, at a reduced value, was sustained.

Based on the proposed interpretation, the enterprise's tax benefit could be recognized in its financial statements because it was based on unambiguous tax law, and because previous positions taken by the company were allowed. The amount of benefit recognized is the best estimate of the amount that is probable of being sustained upon audit.


Once a tax position has met the recognition threshold, a company can continue to recognize the related benefits in its financial statements as long as it is more than 50 percent certain that the position would be sustained in a challenge; that is, it is more likely than not that it would be sustained.

The interpretation requires a company to de-recognize a benefit by recording an income tax liability or reducing a deferred tax asset in the period in which the tax position falls below the more-likely-than-not standard of being sustained. FASB's interpretation does not allow using a valuation account, or a valuation allowance in place of de-recognition.

Measuring tax benefits

After a company concludes that its tax position meets the recognition threshold, it must consider what share of the benefit that it is claiming would be sustained in a challenge.

FASB advises basing that consideration on a best estimate; the amount that most likely would be allowed if the position were contested.

As an example, FASB cites an enterprise planning to claim a $10 million research and experimentation credit on its tax return, comprised of equal spending on four separate projects. Each project is considered a unit of account. The corporation determines that two of the projects meet the probable recognition threshold, while certain expenditures for the remaining two projects present too much uncertainty.

For the two projects that meet the recognition threshold, the company determines that 90 percent of the two $2.5 million claims (a total of $4.5 million) would be sustained in a settlement if that position were contested. That $4.5 million represents the best estimate.

Other criteria

In addition to guidance for recognizing uncertain tax positions and measuring their related tax benefits, the interpretation also provides guidance for asset/liability classification, change in judgment, interest and penalties, and disclosures.

Differences between tax positions and the amounts recognized in the financial statements present liabilities. Those liabilities would generally be classified as current liabilities if payments were anticipated to be made within a year.

Changes in judgments that result in subsequent recognition, de-recognition or changes in best estimate (including interest and penalties) would be recognized in the interim period in which the change in judgment occurs.

When tax law requires interest payments, the accrued interest would be based on the difference between the tax position that has been taken and the benefits recognized in the financial statements. Interest would be accrued in the period in which it was incurred. An applicable penalty would likewise be recognized as a charge to income in the period in which it was incurred.

Loss contingencies related to previously recognized tax positions and tax positions that have not been recognized - in part or in full - as benefits, and that might yield a financial statement benefit in the financial statements, should be disclosed in accordance with FAS 5.

Anticipated impact

While the interpretation addresses financial reporting practices and promotes greater uniformity and comparability in recognizing uncertain tax positions in financial statements, it will significantly affect tax reporting approaches, too.

The interpretation requires that uncertain tax positions and related benefits be recognized, on the presumption that those claims would be sustained in challenges by tax authorities. Positions taken and benefits claimed in tax returns that aren't reflected in an enterprise's financial statements could call into question the veracity of those returns. To avoid such scrutiny, companies may utilize tax return reporting strategies that conform to the interpretation's standards.

Sandy Peiser is the senior tax manager at Fort Worth, Texas-based Weaver and Tidwell.

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