FIN 48 Accounting for Uncertainty in Income Taxes and Other FAS 109 Topics

1. FIN 48Accounting for Uncertainty in Income Taxesand Other FAS 109 Topics

2. Introductions & Agenda

3. Introductions • Glen Kohl, Sr. VP, Tax and TreasuryElectronic Arts • Jeff Sokol, PartnerDeloitte • Rob Terpening, PartnerBDO Seidman LLP • Rusty Thomas, PartnerKPMG • Neil Traubenberg, Vice President, TaxSun Microsystems

4. Today’s Agenda • FIN 48 – Overview • FIN 48 – Difficult Issues • FAS 109 Common Errors

5. Overview - Reason for Interpretation • Diverse accounting practices in applying Statement 109 • Lack of comparability • Evolution of the Standard • Comment Letters

6. Scope – What is a Tax Position? • Tax benefit on return filed or expected to be filed • Reduce income tax expense, taxes paid or payable • Increase tax benefit and receivable, DTA or refund • Decision not to file a return • Allocation or shift of income between jurisdictions • A characterization of income • A decision to exclude income, or treatment of a transaction, entity or other position as tax exempt

7. Step 1 – Initial Recognition of Tax Benefits • Determine “unit of account” • Facts and circumstances in light of all available evidence • Consider: • Manner in which company prepares and supports tax return • Approach the company anticipates the taxing authority will take during an examination

8. Step 1 – Initial Recognition of Tax Benefits • In order to recognize any amount of benefit, for the unit of account, the position must be MLTN of being sustained based solely on the technical merits • The position will be examined • The examiner will have full knowledge of all relevant information • Evaluation based solely on the technical merits • No offset or aggregation of positions • Conclusion should assume resolution in the court of last resort

9. Step 1 – Initial Recognition of Tax Benefits • Highly certain tax positions • Clear and unambiguous tax law • Consistent with “will prevail” opinion • Extent of evidence and documentation requires judgment • Administrative practices and precedent • Applies where there has been a technical violation of law • Expected to be relevant infrequently • Evidence and documentation

10. Step 2 - Measurement • For a tax position that meets the more-likely-than-not recognition threshold… • Measure initially and subsequently as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with a taxing authority having full knowledge of all relevant information • Consider the amounts and probabilities of the outcomes that could be realized upon ultimate settlement • Based on facts, circumstances, and information available at the reporting date

11. Illustrative Guidance – Measurement with Information about Approach to Settlement • Scenario • The enterprise has determined that a tax position resulting in a benefit of $100 qualifies for recognition and accordingly should be measured • The enterprise has considered the amounts and probabilities of the estimated outcomes.

12. Illustrative Guidance – Measurement with Information about Approach to Settlement Table of Probabilities & Estimated Outcomes

13. Illustrative Guidance – Measurement with Information about Approach to Settlement • $60 is the largest amount of benefit that is greater than 50% likely of being realized upon settlement • Actually it’s $60 or more that is greater than 50% likely of being realized upon settlement • Probability of $60 itself is only 25% • The “At least” Test: Book the largest number as to which it is more likely than not that the taxpayer will realize at least that number.

14. Illustrative Guidance – Measurement with Information about Approach to Settlement Table of Probabilities & Estimated Outcomes

15. Illustrative Guidance – Measurement with Information about Approach to Settlement Table of Probabilities & Estimated Outcomes

16. Tax Planning Strategies and Valuation Allowance • Tax planning strategies • Consideration required under FAS 109 • Discussed in paragraphs 20-22 of FAS 109 in conjunction with future realizability of DTA, and corresponding need for (and size of) valuation allowance • If contemplated as source of future taxable income to support realizability of DTA, must meet recognition and measurement criteria of FIN 48

17. Subsequent Recognition, Derecognition, & Measurement • Subsequent Recognition • A tax position which previously did not meet the recognition threshold gets recognized in the first interim period in which: • The more-likely-than-not recognition threshold is met by the reporting date, or • The tax matter is settled through negotiation or litigation, or • The statute of limitations for the tax position has expired • A tax matter need not be legally extinguished to subsequently recognize or measure a tax position • Based on management’s best judgment in view of facts, circumstances, and information available at reporting date

18. Subsequent Recognition, Derecognition, & Measurement (continued) • Derecognition • Derecognize (previously recognized) tax position in the first interim reporting period in which it is no longer more likely than not that the position will be sustained upon examination • Valuation allowance is not a substitute for derecognition • Based on management’s best judgment in view of facts, circumstances, and information available at reporting date

19. Changes in Judgment • Changes in judgment resulting in subsequent recognition, derecognition, or change in measurement of tax position taken previously • If initial tax position was taken in prior annual period, recognize change as “discrete” item in period of change • If initial tax position was taken in prior interim period within same fiscal year, apply APB 28 (Interim Financial Reporting) and FIN 18 (Accounting for Income Taxes in Interim Periods) to take change into account over remaining periods in fiscal year using effective tax rate calculated for interim period • Based on evaluation of new information – not new evaluation, or new interpretation by management, of information that was available in previous period • Analysis must be conducted every reported period

20. Interest and Penalties • Interest • FIN 48 requires accrual if position in tax return is not recognized in financial statements under FIN 48 • When tax law requires interest on underpayment, start recognizing in 1st period it would begin accruing under tax law • Amount is statutory interest rate times difference between FIN 48 tax position and amount taken in tax return • Penalties • Recognize when tax position does not meet minimum statutory threshold to avoid payment of penalties • Recognize in period in which company claims or expects to claim position in tax return

21. Classification • “Unrecognized tax benefit” concept • Difference between position in tax return and benefit recognized and measured under FIN 48 • Creates liability (or reduces amount refundable or DTA, e.g., NOL) • Represents company’s potential future obligation to taxing authority for tax position taken in tax return but not recognized pursuant to FIN 48 recognition/measurement guidance • Again, not actually limited to positions in return but to any tax position • Liability is current or non-current based on expected timing of payment of cash • Current if within one year (or operating cycle, if longer) • Liability recognized is generally not a deferred tax liability • DTL only if it arises from a taxable temporary difference • Interest recognized under FIN 48 – • Accounting policy decision to classify as either income taxes or interest expense

22. Disclosures • Accounting policy for classification of interest and penalties • At the end of each annual reporting period: • Tabular “rollforward” of unrecognized tax benefits (“UTBs”) at beginning and end of period • Total amount of UTBs that, if recognized, would affect the effective tax rate • Total amount of interest and penalties recognized in the income statement and balance sheet • Description of tax years that remain subject to examination by major jurisdictions • Paragraph 21(d) - Positions where it is reasonably possible that the total amounts of UTBs will significantly increase or decrease within 1 year of reporting date • Nature of uncertainty • Nature of event that would cause the change • Estimate of range of change, or statement that “can’t estimate”

23. Disclosures • Tabular rollforward includes: • Gross amts of increases & decreases in UTBs as a result of tax positions taken during a prior period • Gross amts of increases & decreases in UTBs as a result of tax positions taken during the current period • Decreases in UTBs relating to settlements with taxing authorities • Decreases in UTBs resulting from lapses in statutes of limitations

24. Illustrative Guidance - Tabular Rollforward

25. Disclosures • Rollforward/reconciliation “roadmap”? • FIN 48 tabular rollforward requires disclosures only at aggregate level, not at individual tax position level • Not by jurisdiction • Not tax position by tax position

26. Disclosures • Paragraph 21(d) • Positions where it is reasonably possible that the total amounts of UTBs will significantly increase or decrease within 12 months of reporting date • Disclose the nature of uncertainty (i.e. describe tax position) • Disclose the nature of event that would cause the change • Estimate of range of change, or statement that “can’t estimate”

27. The “Reasonably Possible” Catch-22 It’s reasonably possible that I’ll reverse tax reserves in the next twelve months…. Now, I’ve got you… You may, after all, just need those reserves!

28. Disclosures • Paragraph 21(d) – (cont.) • One of the more controversial areas of FIN 48 disclosures – • Define ‘reasonably possible’ • Includes tax positions that are both recognized as well as not yet recognized (due to ‘reasonably possible’ range including probabilities above and below MLTN). • “Nature of Uncertainty” – how much detail must be disclosed? • Boiler-plate will not be acceptable • Significant analysis, documentation and judgment • All this must be performed and disclosed in the correct reporting period. Close scrutiny will be applied to evaluate the quality of the effort and conclusions arrived at in prior periods. Documentation will be an important source of evidence of past analysis and thought process.

29. Effective Date and Transition • Effective for FYs beginning after December 15, 2006 • e.g., calendar year 2007 companies • Early adoption permitted (provided company hasn’t yet issued interim financials for that FY) • Apply more-likely-than-not threshold to all income tax positions for all open years • Recognize cumulative effect of applying FIN 48 as an adjustment to the opening balance of retained earnings (or other appropriate components of equity or net assets in the balance sheet) • SAB 74 requires disclosure of impact of FIN 48 on public company financial statements

30. FIN 48 – Difficult Issues

31. FIN 48 – Difficult Issues • Must all tax positions be evaluated for recognition (and correspondingly documented)? • Said differently, are there tax positions, e.g., transfer pricing, that lend themselves solely to the measurement test? • Exposure draft seemed to acknowledge these issues were more valuation questions, where “technical merits” type of issues don’t come into play.

32. FIN 48 – Difficult Issues • FIN 48 defines scope to include all tax positions. As a matter of practicality, highly certain tax positions do not need to be analyzed. To what extent should companies document tax positions as being highly-certain tax positions?

33. FIN 48 – Difficult Issues • To what extent should FIN 48 be implemented by way of a “bottom-up” inventory approach (i.e., by identifying all material tax positions for each “open” tax year for each jurisdiction) vs. a “top-down approach” (i.e., by starting with identified material uncertain tax positions)?

34. FIN 48 – Difficult Issues • As a result of NOLs or tax credits, the statute of limitations related to certain historical periods is often extended to align with the statutes for years in which attributes were utilized. Notwithstanding the scope of all possible open periods, taxing authorities often limit their examination to years defined within a particular cycle. Is it appropriate to rely on this administrative practice to recognize tax benefits in periods prior to the defined cycle?

35. FIN 48 – Difficult Issues • How should a company apply the measurement standard to positions likely to be sustained or disallowed entirely (e.g., qualification for section 199 deduction where contract manufacturer relationship exists) – i.e., binary issues? • Is it possible that a position that can be recognized pursuant to the MLTN threshold will be measured such that a benefit of less than 50% is recorded?

36. FIN 48 – Difficult Issues • To what extent may a company contemplate “horse trading” – (i.e. using in measurement information about using one position to settle another)? Said differently, can an entity use aggregation of positions or offsetting in measuring a tax position?

37. FIN 48 – Difficult Issues • There appears to be inconsistency between paragraph 10 and paragraph 12 about when entities should subsequently recognize, derecognize and measure a tax position. • Paragraph 10 gives three situations which an entity can use additional information to subsequently recognize the benefits of a tax position including “the tax matter is ultimately settled through negotiation or litigation.” • Paragraph 12 indicates that a tax position need not be legally extinguished and its resolution need not be certain to subsequently recognize or measure the position.

38. FIN 48 – Difficult Issues • Can an entity that has a previously recognized position (i.e., met the more-likely-than not criteria) change the measurement of that position when a tax audit closes and the position was not challenged (notwithstanding the statute of limitation might remain open)? Assume the position was adequately disclosed on the tax return and the subject to IDRs and discussion with the IRS. The case went to appeals and this is not one of the issues as to which there is a proposed adjustment. Of course, there was no closing agreement with respect to that tax position.

39. FIN 48 – Difficult Issues • A taxing authority completes an audit and requires an adjustment to a tax position that was not included in the company’s inventory of uncertain tax position. The company is inclined to cave on this issue. Is the addition of that item to the inventory of uncertain tax positions an error or a change in estimate?

40. FIN 48 – Difficult Issues • Would an entity with NOLs and a full valuation allowance be required to disclose any amounts in their unrecognized tax benefits roll-forward? For example, an entity has $1M R&D credit carryforward for which $900K can be recorded by applying the principle of FIN 48. Would the entity need to reflect the $100K in the FIN 48 tabular disclosure (notwithstanding the NOL DTA would not be recognized in any event due to valuation allowance assumptions)?

41. FIN 48 – Difficult Issues • Consider a scenario where a company owns a hybrid flow-through entity subject to tax in a local jurisdiction in addition to being taxed in the U.S. Does the disclosure requirements of paragraph 21 require that a FIN 48 liability be disclosed to the extent that a local country exposure item, notwithstanding that any increased local tax expense would produce a corresponding US foreign tax credit (economically mitigating the risk item – assuming no U.S. foreign tax credit limitations)?

42. FIN 48 – Difficult Issues • Will entities be required to disclose the fact that the statute of limitations is going to expire in the next twelve months which will create a significant change?

43. FIN 48 – Difficult Issues • Under FAS 123(R), there is a requirement that the tax benefit associated with the excess tax deduction be realized by reducing taxes payable. Since FIN 48 requires that a contingent tax payable be accrued, it would appear that it should be offset by the excess tax deductions not otherwise recognized (so the entry is to debit current tax provision and credit APIC). • If the tax position is not later challenged or if the taxpayer prevails, then the APIC was never realized. Should it then be reversed so that the provision can be credited?

44. FIN 48 – Difficult Issues • Can tax positions that are not individually significant be evaluated in the aggregate when the aggregated amount is material? • Consider, for example, transfer pricing for commission agent or stripped buy/sell subsidiaries, or intercompany debt financing with operating subsidiaries.

45. FAS 109 – Common Errors

46. Tax Accounting for Business Comb. – Foreign Subsidiaries of Target • Same general tax accounting principles apply; deferred tax reporting for book/tax basis differences of inside basis assets/liabilities • Must apply “push down” accounting concepts, even if purchase accounting adjustments maintained in consolidation • In purchase accounting DTA/DTL establishment, imperative that appropriate jurisdictional rates be respected

47. Jurisdictional Rate Example - Cost Sharing Structure in Target – • Nontaxable business combination • Acquiror (A) has a global effective rate of 30% and a US effective tax rate of 40% • Target has a mature cost sharing structure – 50% non-US participant in Singapore • Target (B) has 25% overall tax rate (US 40%, 10% blended non-US rate; 0% rate in Caymans) • Purchase accounting – only identifiable intangible is product rights/IP of $40M • WHAT RATE TO USE FOR THE PURCHASE ACCOUNTING DTL?

48. Interplay of APB23 and CTA • For affiliates reporting in non-US$ FC, currency translation adjustments (CTA) are a component of OCI • If all or a portion of unremitted earnings are not indefinitely reinvested under APB23, deferred tax reporting required on proportionate amount of CTA • Recorded as a component of OCI • Often overlooked, or complicated computations can be prone to errors

49. Tax Effect of CTA on Unremitted Earnings • US Tax DTL Entries • (No APB 23 Reinvestment) • Year 1: 1€ = 1$ • Dr. DTA (FTC) 200 • Dr. Tax Provision 150 • Cr. DTL 350 • Year 2: 1€ = 1.2$ • Dr. OCI 70 • Cr. DTL 70 USP CFC 1,000€ PBT 200 € Tax

50. Valuation Allowance- Indefinite Lived Intangibles • Deferred Tax Liabilities • FAS 142, Goodwill and Other Intangible Assets, stipulates that indefinite-lived intangibles and goodwill are not amortized • FAS 109 requires recognition of deferred tax liabilities and assets for temporary differences related to intangibles and goodwill and the tax-deductible portion of goodwill