FASB Interpretation no. 48, "Accounting for Uncertainty in Income Taxes" (FIN 48, June 2006), prescribes how public and private companies should recognize, measure, and disclose uncertain tax positions in their financial statements. FIN 48 is mandatory for financial statements for fiscal years starting after December 14, 2006. It requires companies to evaluate all "tax positions" and to recognize, for financial accounting purposes, only the tax benefits of those tax positions that are "more likely than not" to be sustained on examination.

FIN 48 applies to all entities that prepare financial statements in accordance with US GAAP, including US partnerships, C corporations, S corporations, and tax-exempt entities, and SEC-registered foreign companies. Thus, FIN 48 affects a USco's Canadian parent or subsidiary whose financial statements must be prepared in accordance with US GAAP, as well as a Canadian company that is registered with the SEC.

Under FIN 48, all (not just uncertain or aggressive) income tax positions (including foreign income tax positions) must be identified--a challenging task for companies that do business in multiple jurisdictions. FIN 48 applies to income taxes only, not to other taxes such as sales and use tax, VAT, and franchise tax. Affected "tax positions" include the decision not to file a tax return (including a return for a US state or foreign jurisdiction); a determination regarding whether a permanent establishment exists; the allocation of income between jurisdictions; the characterization of income on a tax return; the classification of an entity or a transaction as tax-exempt (including classifications of partnerships and non-profits); and any transfer-pricing issue. An entity subject to FIN 48 must do an inventory of all tax positions for all tax years still open to audit; but determining whether a year is auditable is complicated in a jurisdiction where the statute of limitations does not begin to run unless a return is filed. For example, if a Canadian company did not file a US tax return and did not make a treaty election because it believed it had no US permanent establishment, the statute of limitations is open on that tax position, and it may need to be considered for FIN 48 purposes.

Once all tax positions have been identified, a two-step analysis is employed. (1) The company must determine whether it is "more likely than not" (a 50 percent likelihood) that a tax position will be sustained on its technical merits, assuming that the position will be examined and evaluated with full knowledge of all relevant information; the probability of a tax audit or whether the issue would be raised on audit is not relevant to this determination. (2) If it is determined that a tax position is more likely than not to be sustained on the merits, the company can recognize the tax benefit on its financial statements, but only in an amount determined under the rules--namely, the largest amount of the tax benefit that, in the company's judgment, has a greater than 50 percent likelihood of being realized in a settlement with the relevant tax authorities. The amount that cannot be recognized on the company's financial statements as a result of this analysis (the difference between the amount recognized for FIN 48 purposes and the amount reported on a tax return) is reflected as a liability on the company's financial statement relating to an uncertain tax position. The company must also accrue interest and, if applicable, penalties associated with the uncertain tax position. With respect to prior open years, the company is required to adjust its retained earnings rather than its current income tax expenses and net income on its balance sheet. As a practical matter, requiring the amount of a tax position that does not meet the more-likely-than-not standard to be reflected as a liability effectively provides a roadmap for IRS examining agents and other tax authorities.

Appendix A of FIN 48 contains several useful examples of how the two-step analysis should apply in practice. For example, paragraph A.21 breaks down the second step into tabular form. A tax position is assumed to meet the more-likely-than-not standard. The maximum tax benefit that can be recognized on the financial statements is determined on the basis of the "possible benefit outcomes" shown in the table:

Determination of the Maximum Tax Benefit for Financial Statement Purposes

Possible benefit outcome, $	Individual probability of occurring, %	Cumulative probability of occurring, %

100 (complete success)	5	5
80 (very favourable compromise)	25	30
60 (fair compromise)	25	55
40 (unfavourable compromise)	30	85
0 (total loss)	15	100

The possible benefit outcome of $60 is the largest benefit that is more than 50 percent likely to reflect the ultimate outcome; thus, $60 of the $100 benefit can be reflected in the financial statements. The $40 difference between the $100 reported on the return and the $60 thus shown as a benefit on the financial statements is reflected as a liability on the financial statements.

Implementation of FIN 48 raises significant accounting, auditing, and tax issues for US companies and Canadian companies registered with the SEC. Because FIN 48 is already in effect and compliance may be cumbersome for multinational companies operating in multiple jurisdictions, companies subject to these new disclosure rules should develop an approach for implementing FIN 48.

Jessica S. Wiltse