Generally Accepted Accounting Principles have long required that income tax be accrued for all events recognized for financial reporting purposes. Credits expected to be claimed may reduce this tax. Certain limited exceptions apply. Thus, the total income tax of a U. Federal income tax rate times book income, plus state and foreign taxes, less credits to be claimed presently or in the future.
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In essence, the reporting requirements provide a glimpse into how much tax risk a company is prepared to take. Subtopic applies to GAAP-basis financial statements, be they audited, reviewed, or compiled financial statements. Accordingly, Subtopic will not apply to cash-basis financial statements or to any other non-GAAP-basis statements. Subtopic deals with all income tax positions; by definition, it does not apply to sales, use, property, intangible, or value-added taxes. It applies to any income tax in any jurisdiction, whether it is federal, state, local, or foreign income tax, and it applies to any entity that might be subject to income tax.
Subtopic offers a seemingly simple process: Inventory all tax positions for all open years, including the current year, for all jurisdictions; Classify all tax positions as uncertain or routine business transactions meeting the MLTN standard; and Determine whether the tax benefits from uncertain tax positions and how much of those benefits should be reported in the financial statements.
While labeled a "simple process," the client must exercise a great deal of judgment in reaching conclusions in each of these areas.
Also, since Subtopic requires a review of all open years for all jurisdictions, clients must reassess and quantify the consequences of decisions not to file returns or to take aggressive positions made years ago.
Additionally, it also is logical to conclude that there may be an indefinite deferral of any tax benefits, plus penalty and interest issues, if required tax returns are not filed. The administrative issues and problems created by this requirement can be significant. Subtopic provides no safe harbor to deal with these issues, other than the ability to disregard "immaterial" amounts. Clients must be made aware of the effort this will likely take the first year that Subtopic is implemented, since all open years must be scrutinized for uncertain tax positions and the recognition of potential tax liability.
This means conducting a thorough review of the tax returns for each open year to identify material tax positions. It also means that any decision not to file or how to allocate income must be reviewed. The initial requirement to inventory really means that the client must assess each material tax position taken on any income tax return for any open year. Thereafter, each tax position taken in the current year must be inventoried, and prior open issues must be reassessed.
A tax position is any determination of tax treatment in a filed return or a return to be filed that is reflected in the measurement of deferred tax assets or liabilities in any financial statement, including interim financial statements.
This is a broad definition that includes permanent tax reductions and positions that merely defer tax liabilities, as well as a change in the anticipated recognition of tax obligations.
A tax position also encompasses a decision to file or not file a return, interjurisdiction income allocations between states, or the United States and foreign countries , and determinations of whether income is taxable or tax-exempt. For many privately held companies, the most troubling issues are those involving aggressive tax planning in prior years. Since there was no requirement to disclose any of those positions in the tax return, they were invisible to both the IRS and readers of the financial statements.
Now, however, Subtopic requires disclosure of those positions as well as a statement of their impact on the financial statements. Once all of the material tax positions have been inventoried, the provisions of Subtopic can be applied. However, FASB did not intend for Subtopic to have a significant effect on routine, day-to-day business tax transactions that would clearly meet the MLTN requirement and be fully allowed on audit.
Normal business transactions create full tax benefits: H Sales Inc. H properly deducts all sales expenses as they are incurred, including commissions earned as sales are made. It also deducts office salaries, supplies, and utilities.
Since each of these expenses represents a day-to-day transaction that more likely than not will be fully sustained on audit, Subtopic should have no impact on these tax issues. The second step in inventorying tax positions is to determine what the appropriate unit of account is.
While selecting a unit of account might initially seem almost mechanical, it requires a great deal of professional judgment, since all determinations required by Subtopic are driven off the selection of a unit of account. What is clear is that aggregating tax positions for one or more similar items on the return is an option. However, when the total tax position comprises multiple items, it may also be possible to use a separate determination for each component part rather than the aggregate.
The choice of which unit of account to use must be based on the facts and circumstances of each case. Clearly, a smaller unit of account may make it easier to meet the MLTN test, whereas an aggregate tax position with many component parts may have difficulty meeting the MLTN test.
Whichever option is used, it should be consistently applied for each period, unless a change in the facts and circumstances justifies a change in the unit of account. Observation: ASC Paragraph states the "appropriate unit of account for determining what constitutes an individual tax position.
The unit of account should be consistently applied to similar positions from period to period unless a change in facts and circumstances indicates that a different unit of account is more appropriate. Classifying tax positions as uncertain or routine transactions Subtopic distinguishes between routine business transactions that are clearly more likely than not to be fully sustained on audit and those tax positions that have either factual or legal uncertainty.
Accordingly, most small businesses should be able to classify the vast majority of their issues as routine business transactions. Since the goal of Subtopic is really to identify risky tax positions and attempt to reasonably quantify the tax benefits from those positions, routine or highly certain tax positions present little problem.
In fact, for a closely held company, these types of tax issues should be predominant in the financial statements. Where a position is highly certain, little documentation seems warranted. In determining whether a tax position is a routine business transaction or an uncertain tax position, both the technical rules as well as administrative practice can be considered. The use of administrative practices to support a tax benefit deals only with limited technical tax law violations that are commonly ignored by a taxing authority.
Using administrative practice as support for a tax benefit means the matter is widely prevalent and is understood to be so by tax practitioners. The administrative practices concept cannot be used where significant professional judgment is required or where the interpretation of a substantial tax position is required.
Further, the administrative practice rule generally cannot be used where the client is required to self-report a tax violation e. In that case, the question is whether the administrative practice would be to ignore the violation, even though it is not self-reported.
If the violation would still be ignored, then the client can use the administrative practice as support for the tax benefit. If the violation would not be ignored unless it were self-reported, no tax benefits can be considered under the administrative practices exception. Perhaps the biggest advantage to using administrative practices to avoid a Subtopic unrecognized tax benefit arises in the state tax context.
Obviously, a failure to file an income tax return with a state creates a potential tax liability. On the other hand, it also reduces the income tax liability for the state, since the income is reported in the home state.
Thus, in most cases, the failure to allocate and report income to various states may be a net zero-sum event, or at least arguably immaterial. The problem that a nonfiler has, however, is that the statute of limitation does not begin to run until a complete return is filed. Thus, a taxpayer could have a large number of open years with tax liabilities for one state, while the statute on claiming a refund from a state where a return has been filed is generally limited to three years. If the state for which a return must be filed has an administrative practice limiting recovery of income taxes to four or five years, the net difference may be immaterial, eliminating the need to disclose any Subtopic adjustment.
Clients should clearly understand that the purpose of identifying, classifying, and measuring uncertain tax positions is to provide a realistic idea of what the ultimate income tax consequences are of a particular transaction, based upon solid professional judgment. In short, Subtopic requires clients to determine what the likely results of an audit will be long before any taxing authority has even considered auditing the client. This, in turn, can create a conflict between the practitioner and the client as to whether the MLTN test is met and, if it is, what tax benefit can be recognized.
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