The Hindu Business Line : Accounting for uncertainties in income-tax

The effect of tax risk is it could act as a dampener for investment flows since a businessman would like to know exactly what kind of returns can be expected from an investment.

P. S. Kumar

India must rank as a high risk country insofar as tax risk is concerned. Tax risk has two dimensions in the Indian context. Not only are the tax laws fairly complicated but there is also an uncertainty associated with “unpredictable ruling”. If one adds to this the other dimension, which is the Central Government’s predilection for amending statutes retrospectively, the tax risk is hugely magnified.

The effect of these risks is it could act as a dampener for investment flows since a businessman would like to know exactly what kind of returns that can be expected from an investment, and without being able to assess the return on investment no decision can be taken in investing.

Estimation process

Arising out of the uncertainty of tax rulings, there is an accounting problem which surfaces when making an estimate for tax purposes. Estimates are a part and parcel of the process of preparation of financial statements.

Among the estimates that are required, estimate for tax is one of the key ones since the tax expense is computed according to one’s best judgment taking into account the various statutory provisions, anticipated benefits, deductions, etc.

The very nature of the process of estimation carries with it the risk that the ultimate figure of tax liability will materially vary from the initial tax estimate as provided in the financial statements. Financial Executives International listed accounting for uncertain tax positions as one of the top 10 financial reporting challenges in 2006 in the US.

This aspect of financial statements and how the US GAAP addresses the issue are dealt with in this article.

US GAAP

The US GAAP (being rule-based) has probably given more guidance in a detailed manner on this aspect than any other standard. Accounting for Income Taxes is dealt with primarily by Financial Accounting Standard (FAS) 109. However, considering the need for a guidance to address the uncertainties in the preparation of financial statements, the Financial Accounting Standards Board (FASB) issued FASB Interpretation 48 (FIN 48), “Accounting for Uncertainty in Income Taxes”.

As a result of this, where there are doubts or uncertainty with regard to “tax positions”, they have to be addressed for recognition and measurement in accordance with FIN 48.

“Tax position” as used in this Interpretation refers to a position in a previously filed tax return or a position expected to be taken in a future tax return that is reflected in measuring current or deferred income-tax assets and liabilities for interim or annual periods.

The tax position is the stand of the management which may or may not be upheld in the final resolution of the tax liability in the assessment and appellate proceedings which will naturally have the impact of affecting the figures stated as liabilities or assets in the financial statements.

FIN 48 also amends the FAS 5, “Accounting for Contingencies”, to exclude income-tax uncertainties from its scope since in the opinion of the FASB, information received subsequent to the reporting date should not be used to evaluate a tax position at the reporting date.

Deferred taxes

FAS 109 also deals with accounting for deferred taxes. Interestingly, under FAS 109 all deferred tax assets are brought into the books of account initially, and much in the same manner as a provision for doubtful debts is created to acknowledge a potential loss in accounts receivable, an allowance called the “valuation allowance” is created where there is doubt that these deferred tax assets may not be realised (as opposed to Indian standard AS 22 which requires a state of “virtual certainty” and “reasonable certainty” as may be the case to recognise deferred tax assets in the books of account).

The reason for bringing into books of account is to provide as much information as possible to the readers of the financial statements. A valuation allowance is required if it is “more-likely-than-not” that the deferred tax asset will not be realised. “More-likely-than-not” is defined to mean probability of just over 50 per cent.

Taking cue from this definition in FAS 109, the FASB has prescribed similar criterion for FIN 48 also for establishing a tax position if it were to be accepted for financial statements.

This means that after a detailed evaluation, in the opinion of the management there is a probability of more than 50 per cent that the tax position will be accepted by the tax authorities during the examination. Examination for this purpose includes also appellate proceedings. The same position also applies to timing of claims where the deduction is certain but the timing is not.

Under FIN 48 an enterprise cannot recognise a tax benefit in the financial statements unless the chances of the benefit of the tax position being accepted by the taxing authorities in an examination are “more-likely-than-not”.

Therefore, while computing the tax liability for the financial statements, an enterprise must assume (a) the possibility that there may be an audit by tax authorities, (b) that the tax authorities will examine the tax position; and (c) the tax authorities will have full knowledge with regard to the tax positions concerned. Thus, where a tax position does not pass the “more-likely-than-not” test in the opinion of the management, a liability would be required to be created in the financial statements. Along with the liabilities, where applicable, interest and penalties will also have to be provided in the financial statements.

Another requirement of FIN 48 is each of the tax positions must be evaluated independently without offset or aggregation.

An enterprise should derecognise a previously recognised tax position in the first period in which it is no longer more likely than not that the tax position will be sustained upon examination. A change in judgment that results in subsequent recognition, de-recognition, or change in measurement of tax position taken in a prior annual period, including any related interest and penalties, should be recognised in the period in which the change occurs.

FIN 48 prescribes a two-step evaluation for recording uncertain tax positions. The process of evaluation requires an enterprise to first determine whether the more-likely-than-not threshold is met. If not, measure the benefit of the tax position at the largest amount that is greater than 50 per cent likely to be realised.

FIN 48 creates in its wake some genuine problems for enterprises. The major apprehension is that the under FIN 48 where a tax position is taken it should be sufficiently supported by documentation since the management has to demonstrate the process of arriving at the tax position.

This effectively acts as a beacon for tax authorities to target the enterprise. However, the spin-off benefit is that an enterprise is better prepared before the event viz. the assessment of tax undertaken by the authorities. A substantial amount of research and evaluation of the relevant facts will have to be undertaken and, where necessary, will have to be supported by external opinions.

It may be noted that the external auditor is not prohibited from providing a tax opinion when a tax position is being considered. According to the American Institute of Certified Public Accountants (AICPA), such services do not impair an auditor’s independence provided certain safeguards are taken.

There is also a requirement of having to disclose and reconcile tax benefits at the end of each annual accounting period. The disclosures run to increases or decreases in unrecognised tax benefits arising on account of tax benefits taken during a prior accounting period and in the current period, increases or decreases due to settlements with taxing authorities and decreases due to lapse of the statute due to statute of limitations.

There are further disclosure requirements dealing with effective tax rates, interest and penalties and a description of the tax years that remain subject to examination.

FIN 48 is effective for accounting periods commencing after December 15, 2006. However, for non-public companies the date has been extended by a year.

(The author is a practising chartered accountant.)

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