What is an uncertain tax position and how do you account for them under U.S. GAAP? With governments around the world scrambling for tax revenues, this topic has been thrust into the spotlight. This post summarizes the accounting for uncertain tax positions under ASC 740 using a quick worked example.
Tax law is subject to interpretation and it may be uncertain as to whether a tax position taken by a company will be sustained upon review. This uncertainty leads to questions about whether tax positions taken or to be taken on tax returns should be reflected in the financial statements before they are finally resolved with the tax authorities.
ASC Section 740-10-25 defines the threshold for recognizing the benefits of tax-return positions in the financial statements as “more-likely-than-not” to be sustained by the tax authority based solely on its technical merits as of the reporting date. In making this assessment, a company must assume that the tax authorities will examine the position and have full knowledge of all relevant information. In other words, detection risk is not considered in the assessment.
If a tax position is not considered more-likely-than-not to be sustained solely on its technical merits, no benefits of the position are to be recognized in the financial statements. If a tax position meets the more-likely-than-not threshold, it should be measured based on the largest benefit that is more than 50 percent likely to be realized.
At this point, it’s probably good to look at an example.
Granny Smith, Inc. is a subsidiary of Orchard Co. Granny Smith claimed a tax deduction of USD 5 million on its tax return and in its financial statements related to head office royalty charges allocated to them by Orchard. It is probable that, if challenged, the tax authorities will ultimately give Granny Smith a deduction for these charges. However, the amount of the deduction is uncertain, although the likelihood that the deduction will ever be questioned by tax authorities is remote.
Granny Smith considers the amounts and probabilities (if challenged) of the possible estimated outcomes as follows:
|Amount of Deduction||Probability of Acceptance by Tax Authorities||Collective Probability of Acceptance|
|USD 5 million||25%||25%|
|USD 4 million||30%||55%|
|USD 3 million||20%||75%|
|USD 2 million||20%||95%|
|USD 1 million||5%||100%|
Granny Smith uses U.S. GAAP and its income tax rate is 30%.
What amount of tax benefit should be recognized in Granny Smith’s financial statements?
Granny Smith should recognize a total tax benefit of USD 1.2 million. How did we get this?
ASC 740 defines the threshold for recognizing the benefits of tax positions in the financial statements as “more-likely-than-not” to be sustained by the tax authorities. In making the recognition threshold assessment, a company assumes that the taxing authority will examine the position and have full knowledge of all relevant information. Therefore, the fact that it is remote that the deduction will ever be questioned by tax authorities is irrelevant.
The measurement of such tax-return positions is based on the largest benefit that is greater than 50% likely of being realized. Since USD 4 million is the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement, Granny Smith should recognize a tax benefit of USD 1.2 million (USD 4 million x 30%) in its U.S. GAAP financial statements.
What entry should Granny Smith make to record this uncertain tax position?
Assuming a tax benefit of USD 1.5 million (USD 5 million x 30%) was already recorded in the financial statements, a liability USD 300,000 (USD 1 million x 30%) should be recorded representing the difference between the benefit measured under ASC 740 of USD 1.2 million and the tax benefit claimed on the income tax return of USD 1.5 million.
The journal entry would be:
Dr. Current income tax expense (income statement) USD 300,000
Cr. Income taxes payable (balance sheet) USD 300,000
Is there anything else Granny Smith needs to consider?
ASC 740 requires entities to accrue interest expense on the underpayment of taxes if the full benefit of a tax position is not recognized in the financial statements and interest is required to be paid on underpayments of income tax pursuant to tax laws. If the underpayment of taxes is subject to tax penalties, these should also be accrued in the financial reporting period in which the entity claims or is expected to claim the position on the tax return.
The classification of interest and penalties in the income statement is an accounting policy decision that should be consistently applied. ASC 740 permits interest to be charged as either income tax expense or interest expense, while penalties may be recorded as income tax expense or another expense classification. A company is required to disclose in its financial statements how these expenses are classified.
Governments all over the world are in debt and are looking for additional tax revenues. As a result, the accounting for uncertain tax positions under ASC 740 is in the spotlight. We recommend that companies and their auditors brush up on this important accounting topic.