In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48 Accounting for Uncertainty in Income Taxes (FIN 48), which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement 109, Accounting for Income Taxes. FIN 48 was effective for fiscal years beginning after Dec. 15, 2006, for public companies. After two deferrals, FIN 48 is now required to be adopted by private companies for fiscal years beginning after Dec. 15, 2008, which includes all calendar year-end 2009 private company financial statements.
Smart Business spoke with Robert Verzi, CPA, international tax partner with Habif, Arogeti & Wynne, LLP, about why companies need more rigorous evaluation and documentation of their tax position to comply with FIN 48.
What is FIN 48, and how might it affect my company?
FIN 48 is intended to provide a consistent approach to the evaluation, recognition and measurement of the tax benefit related to tax positions. It requires companies to assess whether or not a tax position will be sustained upon examination by the taxing authority.
Under FIN 48, tax positions must be identified, documented, subjected to the recognition test and measured. The first step in this assessment is to identify individual tax positions. There is then a two-step recognition and measurement process. The first step (recognition) is to determine whether a position is ‘more likely than not’ to be realized upon examination by the taxing authority. If a tax position is determined to have a less than 50 percent likelihood of being sustained upon examination by the taxing authority, no benefit may be recognized for that tax position. If a tax position is determined to have a more than 50 percent likelihood of being sustained upon examination by the taxing authority, the second step in the analysis is to determine (measure) the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant taxing authority.
Companies with transfer pricing in cross-border transactions must deal with FIN 48’s more rigorous analysis and documentation procedures. Even if the company has previously performed a transfer pricing documentation study, additional analysis may still be required under the FIN 48 standards.
This represents a more rigorous and frequent process than many companies are accustomed to in evaluating and documenting their transfer pricing strategies, both in the U.S. and other countries.
What is transfer pricing?
When a company sells a product or service to an affiliate or subsidiary, it must establish a transfer price that accounts for the profit or loss on the transaction. It must then report the profit or loss on its financial statements and tax returns. The subsidiary must do the same. Tax authorities, including the IRS, believe that some companies have manipulated the system to report lower income in high-tax countries and correspondingly higher income in low-tax countries.
What is the risk to companies without the proper tax position?
Tax authorities around the world are very aware of the effect transfer pricing policies have on tax revenues. Most will attempt to adjust a company’s taxable income if they determine that the income based on the company’s transfer pricing is inconsistent with pricing that would have been charged to an unrelated company. For example, if a foreign parent’s pricing to its U.S. subsidiary is deemed too high resulting in lower profit for the subsidiary, the IRS may increase the subsidiary’s taxable income. The foreign tax authority is under no obligation to reduce the parent’s taxable income. The result? Double taxation.
Under FIN 48, companies must assume that they will be audited by both the IRS and the relevant tax authority of their foreign affiliate. Let’s take the example of a U.S. subsidiary of a foreign parent. The U.S. subsidiary purchases goods from its parent for resale within the United States. Further assume the U.S. subsidiary incurs tax losses as a result of overpaying for goods purchased from its parent. If management cannot provide adequate support that this transfer pricing policy can be sustained under audit, then a FIN 48 liability may need to be provided on its U.S. financial statement. The FIN 48 liability may be a red flag for an IRS auditor should the company be subject to an IRS examination.
How do I protect my company?
Companies with international operations must implement written transfer pricing policies that satisfy an arm’s length standard and the more stringent standards of FIN 48 for all intercompany transfers. The IRS provides several methods for determining the reasonableness of a policy, but other countries typically use different guidelines established by the Organization for Economic Cooperation and Development (OECD). Companies should work with a tax specialists with the knowledge and experience to help them develop a policy that will keep them in compliance and minimize their global tax liability.
The assessment of tax positions will require the review of all relevant aspects of the tax law including case law and rulings. Appropriate documentation of the assessment of each individual tax position must be maintained by the company. Specialized expertise in the tax law will be required to ensure that adequate analysis and appropriate documentation of tax positions analysis are accomplished.
Robert Verzi, CPA, is an international tax partner with Habif, Arogeti & Wynne, LLP with more than 22 years of experience providing international tax solutions to publicly and privately held corporations on an array of international tax matters, such as foreign tax credit management and utilization, structuring foreign and domestic operations, international mergers and acquisitions, and export tax incentives. He also has many years of experience serving foreign-owned U.S. businesses. Reach him at (404) 898-8486 or email@example.com.