Introduction
GAAP defines a tax position (FASB ASC Master Glossary) to include a filing position on a previously filed return and an expected filing position in a future tax return reflected in measuring current or deferred income tax assets and liabilities for interim or annual periods.
Significantly, the GAAP definition of a tax position includes:
• A decision not to file a tax return
• An allocation or a shift of income between jurisdictions
• The characterization of income or a decision to exclude reporting taxable income in a tax return
• A decision to classify a transaction, entity, or other position in a tax return as tax exempt
• An entity’s status, including its status as a pass-through entity or a tax-exempt not-for-profit entity
The Two-Step Process
GAAP uses a two-step process for evaluating an entity’s tax position taken or expected to be taken in a tax return (FASB ASC 740-10-55-3). Before a tax position can be evaluated through this two-step process, the appropriate unit of account must be determined.
GAAP requires that the determination of the unit of account to be used 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.
(FASB ASC 740-10-25-13)
After the unit of account for determining what constitutes an individual tax position has been identified, the tax position must then be analyzed under the two-step process involving a basic recognition threshold (step one) and a measurement attribute (step two). For purposes of the first step (recognition), an entity must determine whether it is more-likely-than-not that a tax position, based on the technical merits, will be sustained upon ultimate resolution in the court of last resort. (FASB ASC 740-10-55-3) In consider-ing the technical merits, GAAP requires that the entity take into account widely understood past administrative practices and precedents. (FASB ASC 740-10-25-7(b))
A tax position that isn’t recognized (step one) isn’t measured (step two). If a tax position meets the more-likely-than-not recognition threshold and is recognized (step one), then it is measured (step two). (FASB ASC 740-10-30-7)
45
MODULE 1 - CHAPTER 3 - Accounting for Uncertain State Tax Positions
The Recognition Standard
GAAP provides that an entity recognize the 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. (FASB ASC 740-10-25-6)
Because GAAP requires the entity to presume that the tax position will be ex-amined, the likelihood of a tax audit is irrelevant. As one might imagine, the key issue is definition of the phrase “more-likely-than-not. GAAP assumes all of the following criteria when assessing whether the more-likely-than-not recognition threshold is met:
• The tax position will be examined by the relevant taxing authority and the tax authority has full knowledge of all relevant information.
• Technical merits of the tax position derive from sources of tax law authority and facts and circumstances are applicable to the tax position, including considera-tion of certain administrative practices and precedents of the taxing authority.
• Tax position is evaluated without considering the possibility of offset or aggrega-tion with other posiaggrega-tions. (FASB ASC 740-10-25-7)
While a legal tax opinion is not needed to demonstrate that the more-likely-than-not recognition threshold has been met, paragraph B34 of FASB Staff Interpretation (FIN) No. 48 states that “a tax opinion can be external evidence supporting a management assertion and that management should decide whether to obtain a tax opinion after evaluating the weight of all available evidence and the uncertainties of the applicability of the relevant statutory or case law. That paragraph also states that:
[o]ther evidence, in addition to or instead of a tax opinion, supporting the assertion also could be obtained; the level of evidence that is necessary and appropriate is a matter of judgment that depends on all available informa-tion. Thus, the tax opinion of a qualified expert is only one item of evidence that management may consider in reaching its reporting conclusions. (Para-graph B34 of FIN 48 is historical information about the basis for FASB’s conclusions about accounting for uncertainty in income taxes and was not codified in the FASB ASC.)
Derecognition
GAAP also addresses the consequences when a tax position no longer meets the more-likely-than-not recognition threshold. In this event, the position is derecognized (re-moved from the financial statements) by increasing or decreasing the deferred tax liability or deferred tax asset. (FASB ASC 740-10-40-2)
STUDY QUESTIONS
2. What must a taxpayer do before applying the two-step process?
a. Determine a more-likely-than-not tax position b. Measure the tax position
c. Decide whether to file a tax return d. Determine an appropriate unit of account
3. All of the following are true statements about the more-likely-than-not recognition threshold, except:
a. It is assumed that the tax position will be examined by the relevant tax authority.
b. As required, the entity has obtained a legal tax opinion with regard to its tax position.
c. The tax position is evaluated without considering offset with other tax positions.
d. The technical merits of the tax position derive from sources of tax law authority.
¶ 305 APPLICATION
Introduction
The following example highlights some of the key issues that an entity may face when applying GAAP on uncertainty in income taxes to its state income tax positions.
Company A is a retailer that has income tax nexus with all states and files income tax returns in the appropriate jurisdictions. Company A has a subsidiary, Company B, that manages Company A’s intangibles. Company A and Company B also have various intercompany transactions related to management services that Company B provides to Company A. Company B was incorporated in a state without an income tax, and does not file state income tax returns in any state. Both Company A and Company B have been operating at a profit for the last 20 years.
The GAAP definition of “tax position encompasses a decision by an entity not to file a tax return. Therefore, Company B’s decision in the above example not to file state income tax returns in any state is a tax position in each state in which a tax return was not filed.
The unit of account for analyzing each tax position will vary from state to state based, in part, on the approach the entity anticipates the taxing authority will take during an examination. (FASB ASC 740-10-25-13) In other words, the states may use various approaches to attempt to tax Company B’s income. We will now focus on four possible approaches a state taxing authority might take and how the unit of account related to Company B’s non-filing position may vary.
Nexus Approach
A state taxing authority may assert that Company B has nexus (e.g., an economic nexus) with their state based on a statute, regulation, case or other applicable authority.
If an economic nexus approach is expected to be taken by the state, is it possible for Company B to meet the than-not recognition threshold The more-likely-than-not recognition threshold is met if the reporting entity (the taxpayer) concludes it is more-likely-than-not that it will sustain its tax position in a dispute with the state taxing authority if the taxpayer takes the dispute to the court of last resort. (FASB ASC 740-10-55-3)
In the case of a nexus determination, as with other constitutional issues, the court of last resort is the U.S. Supreme Court. Is there more than a 50 percent likelihood that the U.S. Supreme Court would sustain Company B’s tax position on its technical merits?
If not, Company B would account for the direct taxation of its income in all economic nexus states without being able to recognize the benefit of the tax position.
47
MODULE 1 - CHAPTER 3 - Accounting for Uncertain State Tax Positions
Remember that, in assessing the likelihood, Company B would consider widely understood past administrative practices or precedents. (FASB ASC 740-10-25-7(b)).
Company B’s assessment would not include other tax positions, such as those related to apportionment factor determinations. (FASB ASC 740-10-25-7(c))
Forced Combination Approach
A state taxing authority may attempt to force combination of Company A and Company B. If Company B cannot reach the more-likely-than-not recognition threshold that it can preclude forced combination, then the entities would not be permitted to recognize the benefit of the tax position as part of accounting for any tax liability.
However, for purposes of determining any tax liability, additional analysis would be required, as the tax liability under a forced combination may be different than it would be if Company B’s income were taxed directly by the state.
Expense Adjustment Approach
A state taxing authority may attack the transactions between the two companies in an attempt to reduce the expense in Company A. The intercompany transactions between Company A and Company B may give rise to uncertainty in the tax positions if they are not supported by a valuation or a current transfer-pricing study.
What if a transfer-pricing study is in place, but it is based on 10-year-old com-parables and there has been a significant change in facts and circumstances? In both circumstances, this introduces uncertainty about the tax position due to potential state income tax exposure for the entity whose taxable income is understated.
Income Reallocation Approach
Finally, a state taxing authority may look to a more general statutory or regulatory authority to reallocate income between the two related entities to properly reflect the income related to each entity’s activity in the state.
For example, if it is believed that a state will take this approach, and Company B does not believe it is more-likely-than-not that its tax position will be sustained, then Company B must account for income taxes based upon the manner in which it believes the state will reallocate income.
The Look-Back Issue
What if, after determining the unit of account to address the potential attack on Company B’s income (or Company A’s expenses), it is not more-likely-than-not that the entity’s non-filing position will be sustained upon examination in a particular state? In some states, the decision not to file a state tax return may never start the statute of limitations. Under these circumstances, is Company B required to look back 20 years?
In determining a state income tax provision, GAAP requires that an entity consider widely understood past practices and precedents of a particular state to determine the look-back period. (FASB ASC 740-10-25-7(b)) What if the practice or precedent in State X is to analyze each taxpayer’s facts and circumstances on a case-by-case basis to determine the appropriate look-back periods? What is the best way to document this practice or precedent?
These questions need to be addressed to determine whether the more-likely-than-not recognition threshold has been met. A 20-year liability plus growing interest and penalties can quickly become a large amount, even though it is sometimes the case that a state will limit its look-back period to significantly less than 20 years.
STUDY QUESTIONS
4. All of the following are approaches a taxing authority may use when attempting to tax Company B’s income, except:
a. Income Reallocation Approach b. Forced Combination Approach c. Look-Back Approach
d. Nexus Approach
5. Which approach used by a state taxing authority to attempt to tax Company B’s income would require Company A and Company B to support their tax position with a current transfer pricing study?
a. Expense Adjustment Approach b. Forced Combination Approach c. Nexus Approach
d. Income Reallocation Approach