Income tax rules can sometimes be black-and-white, but when it comes to calculating your income tax provision, beware the shades of gray involved in taking a tax position.
What’s a tax position, anyway? It’s simply how a company chooses to interpret and apply relevant tax laws and related authoritative guidance to a specific issue, on a specific return. Even the decision to not file a tax return is a tax position. Since in the real world, legislation, case law, and tax authority practice aren’t always clear-cut, uncertainty (and thus, the need for interpretation) often prevails on tricky issues like the characterization of income or deferred tax treatment.
Some companies are more adventurous than others in dealing with business and regulatory ambiguities, seeing them as opportunities for structuring transactions and aggressive tax planning. But uncertainty is a double-edged sword: if they don’t pass muster with taxing authorities, uncertain tax positions (UTPs) can materially impact your financial statements, and therefore your tax provision. That spells heightened risk for audits, financial restatements—and, of course, more uncertainty downstream.
Knowing how to account for and disclose those gray areas on your financial statements is a task that’s as delicate as it is essential. Fortunately, there’s a framework for that—the Financial Accounting Standards Board’s ASC 740 provides guidance.
What Causes UTPs?
Uncertain tax positions are a fact of life for many if not most companies. Here are some of the most common scenarios that give rise to them:
Ambiguous, complex, or hard-to-interpret tax laws. Let’s face it: tax laws, at best, can be bafflingly complex; at worst, they can be downright contradictory. What’s more, they tend to change frequently, driven by fiscal and legislative pressures or as-yet-unresolved court cases whose outcomes are hard to predict. Those kinds of changes can force strategic pivots, undermine a previously decided tax position, or trigger a cascade of new issues in other jurisdictions.
Transfer pricing. Cross-border activity multiplies the potential universe of uncertainty, with differences between laws and regulations (and, of course, interpretations thereof) leading to head-scratching dilemmas about how to handle transactions that span multiple jurisdictions. Consider transfer pricing—the method by which companies allocate profits and determine pricing for goods, services, or intangibles among related entities domiciled in different countries. The rules governing such transfers are complex, and tax authorities in different jurisdictions will frequently interpret issues like arm’s-length pricing in divergent ways. If any of those authorities challenge a company’s transfer pricing practices, the dispute could create another layer of uncertainty.
Mergers & acquisitions (M&As). You don’t need a cross-border component to a transaction to find yourself in an uncertain tax position. Some M&As can create UTPs by virtue of their complexity, particularly where there are questions about how to allocate taxes and deductions between the acquiring company and the acquired one. Deals that involve tax credits or incentives can create uncertainty around whether (or which) company is eligible for the credits or incentives, and how they should be accounted for. And potential litigation (tax-related or otherwise) around a deal that can deepen that uncertainty.
R&D credits in particular can create uncertainties for a company, due to ambiguity around whether (and which) activities, situations, or expenses qualify for the credit—and if so, how they should be allocated. The rules around R&D credits are notoriously complex, and the eligibility requirements can be difficult to interpret, requiring companies to make all kinds of UTP judgment calls, all of which will impact the tax provision process downstream.
Aggressive tax positions that flow from untested tax planning schemes, international profit-shifting, or credits or deductions that are claimed but not yet sustained by tax authorities definitely give rise to UTPs. So does basic uncertainty about future events—for instance, legislative changes, or changes being contemplated in the company’s business model.
Finally, there’s the uncertainty that flows from… uncertainty. Unresolved UTPs from previous years following challenges from, or disputes with, tax authorities keep flowing downstream—adding to current-year provision issues.
A Certain Degree of Uncertainty: How to Account for UTPs
The process for accounting for uncertain tax positions (UTPs) under ASC 740 involves several steps, which revolve around judgments a company must make before closing the books. Most of these steps will have a significant impact on the tax provision, as we’ll see shortly. Here’s the playbook:
- Recognition. First, identify and document any and all tax positions that may not be fully supported by tax law or precedents. Then, evaluate the technical merits of each position using case law and any other relevant information to recognize whether the position is more likely than not (“MLTN,” see sidebar) to be sustained upon examination by the tax authority.
- Measurement. If you determine that your tax position is MLTN to be sustained by the tax authority, you can measure the expected tax benefit—using the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement—and recognize it on your financial statements. If, however, a position doesn’t pass the MLTN threshold (again, on the technical merits), you cannot recognize those hoped-for benefits on the financial statements. These unrecognized tax benefits generally result in an increase in a liability for income taxes payable, a reduction of an income tax refund receivable, a reduction in a deferred tax asset, and/or an increase in a deferred tax liability.
- Reserve. Companies are required to keep a reserve that reflects the uncertainty associated with their tax positions. So, if one or several of your own fail the MLTN test, you must set aside enough reserve to cover the range of potential tax liabilities should they be challenged by the tax authority. Many companies use a cumulative probability model (see sidebar) to game out the range of possible outcomes based on various scenarios. This can help to reduce the risk of over- or underestimating the reserve and ensure that it reflects in good faith the true economic impact of the UTP on the company’s tax position. The good news: If the UTP gets resolved in your favor, you can then release the reserve—and recognize the tax benefit in the income statement.
- Disclose. While requirements can vary by jurisdiction, under ASC 740, companies must disclose all information necessary to provide a complete understanding of their uncertain tax positions. These could include not only the nature of the tax position, the amount of tax benefit or liability recognized, the amount of the reserve, and any interest or penalties that may apply, but also the full panoply of reasons why the position is deemed to be uncertain—e.g., uncertainty around the resolution of court cases, interpretation of tax laws, or the estimated likelihood of success upon examination by the tax authority. You should also include an estimated range of potential tax liabilities and the status of any ongoing examinations or disputes.
- Monitor & update. When it comes to tax law, conditions can change more often than the weather. You don’t want to get caught in a sudden regulatory rainstorm—or find something material has happened between the reporting date and when your financial statements are released. That’s why it’s important to continuously monitor developments related to your UTPs—including outcomes of regulatory reviews, changes in tax laws, or new precedents—and update your reserves and disclosures as necessary.
How Uncertain Tax Positions Affect the Tax Provision Process
So, what do all these UTP accounting steps actually mean for your tax provision? Potentially a great deal—because the tax provision is intimately connected to the company’s income tax expense and deferred tax balances for financial reporting purposes.
Consider the UTP reserve mentioned above: essentially, that’s a provision for future tax liability that’s recognized in the current period. The reserve will increase the company’s income tax expense as a percentage of pre-tax income—its effective tax rate, or ETR. If the UTP is later resolved in the company’s favor and the reserve is released, that will decrease the tax provision by the same amount, bringing down the ETR.
If a UTP passes the 50% recognition test—meaning it’s deemed more likely than not to be sustained upon examination—the tax benefits associated with the position, as computed using the cumulative probability model, are recognized in the tax provision, which will result in a lower tax liability and higher net income for the company: thus, a lower ETR. But if the UTP doesn’t pass that test, then those tax benefits cannot be recognized—meaning a higher tax liability (the reserve) and ETR, and lower net income for the company. Also, keep in mind that incorrectly recognizing benefit on the financial statements (if determined to be material) may require a restatement of prior-year financial statements, which can impact the company’s tax provision for those years as well.
And what about those required UTP disclosures in the financial statements? While they may not have a direct impact on the ETR, they do provide important information to investors and other stakeholders about the company’s potential tax liabilities, and the risks associated with its tax positions—factors which ultimately could affect the company’s stock price and other financial metrics, including the ETR.
The Bottom Line
Uncertain tax positions don’t necessarily mean there’s non-compliance with tax law. They merely reflect the complexity of a tax system that’s overlaid on an increasingly complex business ecosystem—and the need for interpretation and judgment in applying tax laws, under ASC 740 accounting rules.
But one thing is not in doubt: no matter what stance you take in making your position—aggressive or cautious—you must ensure you have sufficient documentation and support for that position. How much you might end up having to pay in penalties and interest in the event of a tax audit or dispute that isn’t adequately supported is not the kind of uncertainty you want to be discussing with your board.