Uncertain Tax Positions: New Guidance Impacting the Bottom Line

Uncertain Tax Positions: New Guidance Impacting the Bottom Line Thomas D. Klein, CPA University of Arizona Faculty Member Former National Director, Deloitte & Touche, L.L.P. November 1, 2007 Boston

Council Member Biography Thomas Klein is a Faculty Member in the University of Arizona's Eller College of Management. Mr. Klein teaches taxation and financial accounting courses, both at the undergraduate and graduate (MBA, Masters of Accounting) level. He is also the Managing Member of KleinCPA and a former Deloitte National Firm Director. Mr. Klein has over 20 years of experience in the practice of public accounting (Audit, Taxation, & Financial Accounting). Mr. Klein’s teaching interests in the tax area include corporate, multistate, and multinational taxation and mergers & acquisitions; teaching interests in the financial accounting area include earnings management, accounting for stock compensation plans, accounting for income taxes, leases, and consolidations and the statement of cash flows. Mr. Klein has extensive industry expertise in the Healthcare and Retail areas. He has authored feature articles in many of the accounting profession's top journals.

Topics • Overview of FIN 48 and comparison to former treatment under FAS 5 • Identifying and measuring tax positions that are uncertain • Distinguishing between different types of uncertain positions • Evaluating the impact of uncertain positions on financial reporting results and cash flows • Interpreting the new income tax footnote disclosures

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Table of Contents • Why are tax positions uncertain? • Former treatment under FAS 5 • Brief overview of FAS 109 basics (Accounting for Income Taxes) • FIN 48 overview • Identifying, evaluating and measuring uncertain tax positions • FIN 48 implications • Financial reporting consequences as of the adoption date • Financial reporting and cash flow consequences thereafter • New footnote disclosure requirements

Disclosure of Liabilities for Unrecognized Tax Benefits as of 1/1/07: *Includes related accrual of interest and penalties. On the balance sheet, the liability for UTBs, interest and penalties is typically included in “Accrued Other and Current Liabilities” and “Noncurrent Liabilities”.

Why are Tax Positions Uncertain? • Realistic Possibility Standard (a.k.a. “reasonable basis”) • Generally recognized as the appropriate standard by the: • ABA • AICPA • IRS • Exception • Tax positions that do not satisfy the standard but are • Not frivolous, and • Properly disclosed

Without Merit (0%) Certain (100%) Realistic Possibility Spectrum of Uncertain Tax Positions(probability that taxpayer will ultimately prevail in the uncertain position) position generally does not require disclosure in the tax return not frivolous and properly disclosed?

FAS 5 v. FIN 48 Treatment • FAS 5 • Liability is accrued if it is probable that a liability has been incurred (and it can be reasonably estimated) • Not separately disclosed • FIN 48 • Liability is accrued if it is not more-likely-than-not that uncertain tax position will be sustained • Separately disclosed

Scope of FIN 48 • FIN 48 applies to income taxes • It does not apply to other, non-income taxes such as property or sales taxes. Those taxes remain subject to the rules under FAS 5. • Income tax positions include: • Deductions taken • Taxable income excluded or recharacterized • Conclusions to not file an income tax return • Conclusions that an entity or transaction (e.g., a reorganization) is tax-free

not more-likely-than-not that the position will be sustained a partial liability may be required despite being M-L-T-N probable that a liability has been incurred Without Merit (0%) Certain (100%) Realistic Possibility More-Likely -Than-Not (FIN 48)* Probable (FAS 5) Spectrum of Uncertain Tax Positions(probability that taxpayer will ultimately prevail in the uncertain position) *This assessment must assume that: 1) the position will be examined, 2) the examiner will have full knowledge of all relevant information, 3) resolution will be based solely on the technical merits, and 4) the matter will be resolved in the court of last resort

Tax Rate Deferred Tax Liability (Balance Sheet) 35% 3,500 Deferred Tax Expense 3,500 Income Tax Expense (per books) 35,000 FAS 109 (Accounting for Income Taxes) Primer Pre-tax Book Income $100,000 1st year tax write-off of depreciable equipment ($12K less $2K of deprecia-tion included in pre-tax income above) (10,000) Taxable Income 90,000 Income Tax Payable (35%) 31,500

Tax Rate Deferred Tax Liability (Balance Sheet) 35% 0 Deferred Tax Expense 0 Income Tax Expense (per books) 31,500 FAS 109 (Accounting for Income Taxes) Primer Pre-tax Book Income $100,000 Production Activities Deduction (10,000) Taxable Income 90,000 Income Tax Payable (35%) 31,500

Temporary v. Permanent Book to Tax Differences • Temporary Difference: A difference in the book and tax treatment of an item that will reverse in a subsequent year (e.g., depreciation, installment sales, certain prepaid income, etc.) • Permanent Difference: A difference in the book and tax reporting of an item that will not reverse in a subsequent year (e.g., research and experimental credits, production activities deduction, meals and entertainment expense, fines and penalties, etc.)

FIN 48 Overview • Effective date • Fiscal years beginning after December 15, 2006 • Transition • Cumulative effect in opening retained earnings (or other appropriate components of equity or net assets) • Prior to recognizing the benefit of a tax position for financial reporting purposes, the tax position must be more-likely-than-not (MLTN) of being sustained based solely on its technical merits • Tax positions not eligible for benefit recognition are generally recorded as a liability (“unrecognized tax benefits”) for financial reporting purposes • The impact on earnings largely depends upon whether the uncertain tax position relates to a temporary or permanent difference

Effective date (1/1/07) for calendar year companies(record FIN 48 liability, reduce retained earnings*) Other potential uncertain positions identify and measure uncertain positions 12/31/03 12/31/09 12/31/. . . 12/31/04 12/31/05 12/31/06 12/31/07 12/31/08 Identify Uncertain Tax Positions * Generally, only to the extent that FIN 48 liability is in excess of the FAS 5 liability previously recorded

Evaluate Tax Position for Recognition • In order to recognize any amount of benefit related to a tax position, the position must be MLTN of being sustained. • This evaluation must assume: • The position will be examined • The examiner will have full knowledge of all relevant information • Resolution will be based solely on the technical merits • The matter will be resolved in the court of last resort

Consider RecordingFIN 48 Liability Record FIN 48 Liability Without Merit Certain Realistic Possibility More-Likely -Than-Not Spectrum of Uncertain Tax Positions 99% Probability of success

Measure Benefit to be Recognized • A tax position to be recognized is measured • Unlike recognition, enterprises do not base measurement solely on the technical merits of the tax law (i.e., resolution in the court of last resort) • Instead, possible outcomes include the enterprise’s plan for settlement • the tax benefit is limited to the largest amount that is greater than 50% likely of being realized

Consider RecordingFIN 48 Liability Record FIN 48 Liability Without Merit Certain Realistic Possibility More-Likely -Than-Not Evaluate Tax Position for Recognition 99% Probability of success

Cumulative Probability Assessment * * Table source: AICPA, Practice Guide on Accounting for Uncertain Tax Positions under FIN 48

Accrual of Interest and Penalties • Interest (and, potentially, penalties) must be also be accrued on uncertain tax positions. It should be accrued from the date on which the tax on the uncertain tax position would have been due. • FIN 48 permits interest and penalties to be classified as a component of “income tax expense” or separately as “interest expense” and “penalties” (i.e., before arriving at pre-tax income).

FIN 48 Implications • Financial Reporting Implications • How and when will FIN 48 impact financial statements? • Balance Sheet • Statement of Earnings (i.e., the effective tax rate and thus EPS) • Cash Flow Implications • How and when will FIN 48 impact cash flows?

Effective date (1/1/07) for calendar year companies(record FIN 48 liability, reduce retained earnings*) Other potential uncertain positions identify and measure uncertain positions 12/31/03 12/31/09 12/31/. . . 12/31/04 12/31/05 12/31/06 12/31/07 12/31/08 Identify Uncertain Tax Positions * Generally, only to the extent that FIN 48 liability is in excess of the FAS 5 liability previously recorded

Reassess existing uncertain positions and consider new positions; record net increase/decrease to FIN 48 liability and adjust provision for taxes Effective date (1/1/07) for calendar year companies(record FIN 48 liability, reduce retained earnings*) Other potential uncertain positions Reversal period of most adoption date uncertain positions identify and measure uncertain positions 12/31/03 12/31/09 12/31/. . . 12/31/04 12/31/05 12/31/06 12/31/07 12/31/08 FIN 48, Post Adoption * Generally, only to the extent that FIN 48 liability is in excess of the FAS 5 liability previously recorded

Survey on Expected Earnings Volatility Percentage of respondents that expect FIN 48 to result in: • much more earnings volatility 4% • somewhat more earnings volatility 51% • the same or less or earnings volatility 45% Source: CFO.com (Survey of 43 Corporate Controllers and Tax Directors from the Controllers’ Leadership Roundtable at the Corporate Executive Board)

FIN 48 Implications • Financial Reporting Implications • How and when will FIN 48 impact financial statements? • Balance Sheet • Statement of Earnings (i.e., the effective tax rate) • Cash Flow Implications • How and when will FIN 48 impact cash flows?

Footnote Disclosures – Pre-FIN 48 • A Reconciliation of Statutory to Effective Tax Rate • The Components of Income Tax Expense • Current and Deferred for: • Federal • State • Foreign • A schedule of temporary differences and carry-forward items (tax effected) that collectively represent the DTA or DTL on the balance sheet

Footnote Disclosures – Post-FIN 48 • In addition to all previous disclosures: • A tabular reconciliation, on a worldwide aggregated basis, of the total amount of unrecognized tax benefits at the beginning of the period to the total amount of unrecognized tax benefits at the end of the period. • The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate. • For positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly increase or decrease within 12 months of the reporting date: • (1) The nature of the uncertainty • (2) The nature of the event that could occur in the next 12 months that would cause the change • (3) An estimate of the range of the reasonably possible change or a statement that an estimate of the range cannot be made. • A description of open tax years by major jurisdictions. • The total amounts of interest and penalties (1) recognized in the statement of operations and (2) recognized in the statement of financial position. • Contractual obligations disclosure

Footnote Disclosures – Post-FIN 48 Tabular Reconciliation Disclosure (In thousands)

Footnote Disclosure Example: Transaction Resulting in a Significant Decrease in Unrecognized Tax Benefits within 12 Months of the Reporting Date “On September 15, 2007, the statute of limitations is expected to expire on $2,500,000 of research credits claimed in the Company’s 2003 tax return for expenditures related to the development of MotuRx. The Company is uncertain as to the qualification of certain expenditures related to contract services rendered by an unrelated third party provider.”

Footnote Disclosure Example: Transaction Resulting in a Significant Decrease in Unrecognized Tax Benefits within 12 Months of the Reporting Date “On September 15, 2007, the statute of limitations is expected to expire on tax benefits amounting to $2,500,000. The tax benefits relate to the development of one of the Company’s proprietary products.” Note: This type of disclosure is also required for an expected significant increase in the balance of unrecognized tax benefits within 12 months of the reporting date.

SEC Comments Regarding Initial Disclosures • SEC has begun to comment on the adequacy of disclosures • Many more companies will be reviewed next year • Early indication is that the SEC may be looking for more detailed disclosure • Example of excerpt from SEC comment letter: • We note your disclosures regarding the transfer pricing uncertainty and the various other uncertain tax positions related to federal taxes which are being discussed at the IRS Appeals level in the U.S. Tell us how you have met each of the disclosure requirements of paragraph 21d of FIN 48 for each significant uncertain tax position? SEC official Joe Ucuzoglu recently stated that “The SEC's main focus in enforcing FIN 48 will be ensuring investors get the information they need, not to point out tax issues to IRS.” However, the SEC official said, "they absolutely do need enough description so they understand the risks companies are taking."

financial statement issue date statute expiration date for 2003 tax return (9/15/07) 12/31/03 12/31/09 12/31/. . . 12/31/04 12/31/05 12/31/06 12/31/07 12/31/08 Footnote Disclosures – Post-FIN 48 12 months from reporting date reporting date (i.e., balance sheet date) Note: Expected material changes from the 10-K disclosure should be disclosed in the subsequent quarterly filings.

Footnote Disclosure Example:Contractual Obligations Disclosures * In theory, the amount included here could represent some or all of the liability for unrecognized tax benefits that the Company believes will never materialize.

Summary • Adoption of FIN 48 has resulted (or will result) in the recording of additional liabilities (likely both current and non-current) and a corresponding adjustment to retained earnings • Thereafter, • Existing liabilities will be settled or otherwise expire each year • Certain expiring liabilities will result in the recognition of tax benefits on the statement of earnings (more so for permanent differences, less so for temporary differences) • Certain liabilities may not reverse over time to the extent that they relate to returns not filed • Additional liabilities will be recorded each year for originating uncertain tax positions • Certain originating liabilities will result in the recording of additional tax expense on the statement of earnings (more so for permanent differences, less so for temporary differences) • Cash flows will be impacted to the extent that: • Companies become more conservative in their tax filing positions • Tax authorities become more successful in asserting underpayments of tax due to the new footnote disclosures

Questions?

Uncertain Tax Positions: New Guidance Impacting the Bottom Line