Tax Accounting Practices in a UTP Disclosure Environment
By David L. Bernard
Tax Blawg’s Guest Commentator, David L. Bernard, is the recently retired Vice President of Taxes for Kimberly-Clark Corporation and a past president of the Tax Executives Institute.
It is not too soon for in-house tax professionals to be thinking about how the disclosure of uncertain tax positions (required beginning with 2010 tax returns) will change their lives and perhaps their historical practices.
There are plenty of questions about the new requirement and, not least among them, doubts that it will produce the results the IRS anticipates. The most obvious question is whether the potential over-disclosure of temporary differences and the required disclosure of maximum exposure by issue will bog down the audit process and lead to more unagreed issues going to Appeals or to the courts. Notwithstanding the controversy, tax professionals would be wise to forget arguing about the merits of the new draft requirement and begin thinking about their responses; this is going to happen!
The instructions for Schedule UTP require the reporting of a corporation’s federal income tax positions for which the corporation or a related party has recorded a reserve in an audited financial statement. In case this net is not broad enough, the instructions extend the reporting requirement to tax positions for which a reserve has not been recorded based on an expectation of litigation or an IRS administrative practice. Making matters worse, with certain exceptions, the taxpayer must also disclose the Maximum Tax Adjustment (MTA) potentially related to each disclosed uncertain tax position.
Example 5 of the Schedule UTP instructions attempts to clarify the Service’s intentions relating to the “expectation of litigation” language. Essentially, disclosure is required in situations where the taxpayer concludes that there is less than a 50% probability of settling the issue with the IRS, but greater than 50% chance of prevailing in litigation. As discussed later, this may change the ASC 740-10 (formerly known as FIN 48) calculus.
Evaluate Your Reserve Positions Strictly in an Examination or Appeals Forum
One of the first things taxpayers should do is identify and evaluate all uncertain tax positions for which no reserves have been provided. These will include any issues for which your research and analysis lead to a conclusion that you have a greater than 50% chance of prevailing on 100% of the dollars at issue. However, ASC 740-10 analyses may not have thoroughly incorporated the prospects for an issue at the examination level or in Appeals; for example a “more likely than not” or “should” level tax opinion may have been used to defend a no-reserve decision. Under the Service’s new guidance, taxpayers should analyze prospects for success at each step: the examination, Appeals, and litigation. If there is a greater than 50% probability that you can convince the field that no adjustment is appropriate, then not only is no reserve required, but also no disclosure of the uncertain tax position.
If you cannot meet this threshold with the field, then the question must be applied in the Appeals setting. If the analysis concludes that there is a greater than 50% probability that you will prevail on 100% of the amount at issue in Appeals, again the answer is no reserve and no disclosure. Conversely if the analysis concludes that it is probable that some amount would have to be conceded to resolve the issue in Appeals and that such a concession is preferable to the possibility of long and costly litigation, a reserve will be required consistent with the cumulative probability analysis required by ASC 740-10.
Consider Disclosing Specific Amounts of Reserves for Certain Issues
Taxpayers that maintain small percentage reserves because of a desire to resolve issues short of litigation should consider whether disclosure of the specific reserve amounts in such cases is appropriate. Before discounting this as insanity, consider the following fact pattern. Assume that you have an issue with a MTA of $25 million for which you have a strong “should” level opinion in hand. Assume also that your ASC 740-10 analysis indicated a 20% reserve was necessary to resolve the issue at Appeals, and that your company wants to avoid litigation regardless of the ASC 740-10 analysis in that forum. Your tax return will reflect a MTA of $25 million and absent disclosure of the specific $5 million reserve, the field will be left to wonder how large the reserve is and whether their technical analysis of the issue is falling short, i.e. “what are we missing”. This could lead to an endless cycle of IDRs while the agent tries to find justification to set up a $25 million adjustment. The downside is that if the issue is adjusted on audit, Appeals will know that the 20% reserve exists and may therefore be less likely to concede 100% of the issue.
Test Your Post-Cushion Hangover and Modify your FIN 48 Approach
The days of “tax cushion” accounting have long passed and the sheet of paper summarizing the cushion kept in the VP’s desk drawer has been replaced with voluminous documentation and analysis of each uncertain tax position. While the intention of ASC 740-10 is to require a more disciplined and objective process in establishing tax reserves, force yourself to consider whether there is still a tendency to establish reserves more conservatively than is required, (the “cushion hangover”).
One of the ways you can judge your conservatism is by reviewing your audit and appeals history. For example you might make a list of the issues for which you have had reserves, showing the reserves originally established in the next column, the RAR treatment in the next column, and the final Appeals treatment in the final column. If this analysis suggests that you consistently resolve issues on a more favorable basis than your original reserve calculation, you may be suffering from post-cushion hangover. While it will be very difficult to change the level of reserve established for any issue in a prior year, this analysis may assist you in defending future, less conservative, tax accounting decisions. The bottom line is that taking the over-conservatism out of the tax accounting decisions will lead to fewer reserves under ASC 740-10 and less disclosure under the newly proposed rules.
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