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FIN 48: Accounting for Uncertainty in Income Taxes

Today’s post is a guest post from a colleague of mine.  His name is William Crozier and he has over sixteen years of experience dealing with tax issues including their proper financial reporting.  William has his own consulting practice providing temporary tax function management, support and advisory services.

The time has finally come for private companies that issue GAAP financials to implement FIN 48 – Accounting for Uncertainty in Income Taxes.

On July 13, 2006, the FASB issued FIN 48, the most significant change to accounting for income taxes since the adoption of the liability reporting method or FAS 109.  The purpose of FIN 48 is to clarify the recognition of uncertainty by establishing a minimum threshold a tax position is required to meet before being recognized in the company’s financial statements.  FIN 48 applies to taxes covered by FAS 109 for regular for-profit organizations, pass-through entities such as partnerships, non-taxable entities, REITs and other registered investment companies.

Recognition under FIN 48 works based on a two-step process of recognition and measurement.  Recognition occurs when a tax position, based on its technical merits, is more likely than not to occur.  The amount recognized or measured will be the largest amount of benefit or liability that is more likely than not to be realized upon ultimate settlement, determined on a cumulative probability basis.

The recognition now required under FIN 48 clarifies the recognition and measurement previously done under FAS 5. The most intrusive or disheartening aspect of FIN 48 is its new disclosure requirements.  The new rules now require a tabular roll forward of the beginning and ending aggregate unrecognized tax benefits plus the specific detail related to tax uncertainties for which it is reasonably possible that an amount of unrecognized tax benefit will significantly increase or decrease within twelve months.  The “rub” comes from the fact that work product previously protected by client-attorney privilege could lose its protection since it will now have to be revived by outside auditors in support of reporting under FIN 48.  The Internal Revenue Service has had a “Gentlemen’s Agreement” that they would not automatically request FIN 48 work papers but has reserved the right to do so on an individual basis.  One such request is currently working its way through the courts.

So, what does this mean?

As with any new pronouncement from FASB, it means a lot of work.  The first thing you will want to do, if you haven’t done so already, is to meet with your outside auditors as soon as possible to scope out document requests and plan their review.  A proper FIN 48 review will look at every issue, no matter if it is questionable or not.  For example, if you have a subsidiary that pays a tax-free dividend to its parent every year, as part of your FIN 48 review process, you will have to document its proper tax treatment even though it is established law.  To give the reader an idea of the possible documentation needs, a recent FIN 48 review that I was involved with for a medium-sized multinational company consisted of about eight medium sized three-ring binders.