2007 OFII Tax ConferenceAventura, FL 1 FIN 48 Applicability to Inbound Companies

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2007 OFII Tax Conference Aventura, FL

FIN 48 Applicability to Inbound Companies

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Michael Burak – PricewaterhouseCoopers Nathaniel Carden – Mayer Brown Rowe & Maw

The views expressed in this presentation are not intended as, and should not be relied on, as accounting, auditing, regulatory or tax advice. The outcome of any independent situation depends on the specific facts and circumstances in which the issue arises and on the interpretation of FAS 109 and other relevant literature, laws and regulations in effect at the time.

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Agenda

Fin 48 Overview SAB 74 & 10-Q Trends Inbound v. Outbound Disclosure

Requirements Key Implementation Considerations

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Transparency developments• IRS Developments

– Reportable transaction regulations – Policy with respect to “tax accrual” work papers

(Announcement 2002-63)– Schedule M-3

• SEC Developments– December 2003 MD&A guidance– Reportable transactions regulations– SEC Chief Accountant statement in 2004– SEC comment letters

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FIN 48 – Scope and Summary – Applies to domestic and foreign SEC registrants– Covers all tax positions accounted for in accordance

with FAS 109

– Effective for annual periods beginning after December 15, 2006

– Income tax uncertainties

– Change in net assets considered as change in accounting principle

– SAB 74 disclosure

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Potential Tax Positions/Unit of Account

• Federal tax examples:

– Character of Income– Income Recognition– Accounting Methods– IRC Sec.199– R&E Tax Credits– Merger & Acquisition Transactions– Purchase Price Allocations (Valuation)– Hedging & Other Treasury Transactions– Transaction Cost Analyses– Executive compensation/Stock options– FSC/ETI– IRC Sec. 382

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Potential Tax Positions/Unit of Account

• International Tax (US and Non-US) examples:

– Permanent Establishment – Transfer Pricing– Withholding Tax– Debt/equity Determination– Treaty Positions– Hedging and Foreign Currency– Anti-deferral Regimes (i.e., US Subpart F)– Foreign Tax Credits– IP Migration– Cross Border Financing– Specific Jurisdictional Issues– Tax Holidays– Cash Repatriation

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Tax Positions/Unit of Account• State Tax examples:

– Nexus

• P.L. 86-272

• Economic Nexus

• Agency Nexus

– Unitary/Combined Filing Groups

– Apportionment Filing Positions

• Gross vs. Net Receipts

• Intercompany Sales/Eliminations

• Cost of Performance

• Joyce vs Finnegan

– Taxable Income

• State Addbacks and Exceptions

• State Depreciation Adjustments

• State Dividend Received Deductions

• Business/Non-Business Income

• Transfer Pricing

– Affiliated Entities

• Intangible Holding Companies

• Factoring Companies

• Finance Companies

• Captive Insurance Companies

• Sales Companies

• Procurement Companies

• REIT/RIC

• Check-the-box entities

– Tax Attributes

• Net Operating Losses

• Credits

– Impact of Federal & International Tax Positions

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Two-Step Process• Recognition: A tax benefit from a UTP may only be recognized if it

is “more likely than not” that the position is sustainable based solely on its technical merits (i.e., excluding detection risk) and any relevant administrative practices. All positions should be evaluated, even if not yet filed.

• Measurement: The tax benefit of a qualifying position is the greatest amount of benefit that is cumulatively >50% likely of being realized.

• Subsequent recognition and measurement: The assessment of the recognition threshold and the measurement of the associated tax benefit are subject to change based on new information. Unrecognized tax benefits should be recognized (derecognized) in the period the position reaches (falls below) the recognition threshold, which may occur prior to final resolution of the matter.

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Key Concepts & Issues– Netting

– Interest & Penalties

– Indemnifications

– Refund claims

– Timing items

– Valuations allowances & NOLs

– Business combinations

– Subsequent events

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Audit issues – Multiple Adjustment Theories

• U.S. subsidiary responsible for U.S. portion of multinational business

• Foreign parent provides periodic services to affiliates, including U.S. subsidiary. Files 1120F asserting no U.S. business income

• Prior audit experience– IRS focused on transfer price paid to

FP and deducted by U.S. Sub– No attention to FP’s return or income

U.S. Sub(U.S.

taxpayer)

ForeignParent

(Protective 1120F Filer)

Payment for Service

Services Rendered

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Analysis of U.S. Sub’s Deduction

• Sections 162/482

• Focus on – Functions performed for U.S. Sub– Benchmarks used for prices or markups

• U.S. Sub deduction turns on– Demonstration of benefit– Appropriateness of price paid to FP

Analysis of FP’s Income

• Treaty (if applicable) and U.S. ECI rules

• Focus on– Existence of Permanent Establishment– U.S. Trade or Business

• FP income turns on – Attribution of income to PE– U.S. ECI rules

Resulting US deduction and FP income should be similar, but underlying analyses are potentially quite different

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Tax Position

• FIN 48 defines “tax position” as – “a position in a previously filed tax return or a position expected to be taken

in a future return”– Also includes “characterization of income or a decision to exclude reporting

taxable income”

• Are these two tax positions?– Two separate returns– Related facts, but distinct legal theories

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Recognition

• Requires more likely than not conclusion on each tax position– Less significant for U.S. Sub

• Does arm’s length standard govern?• Is cost-based charging permissible?

– More complex for FP

• FIN 48 states that “[e]ach tax position must be evaluated without consideration of the possibility of offset or aggregation with other positions

• Unclear what happens to US transfer pricing position if you cannot reach more likely than not for FP

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Measurement

• Similar analysis for US Sub and FP—what is the amount of U.S. tax benefit greater than 50 percent likely of being realized?

• Logically, measurement prong is where interaction between two tax positions should occur– Disallowing deductions and taxing income simultaneously is facially inconsistent– Analogous to multijurisdiction/competent authority analysis

• Prior audit experience—including, presumably, treatment of issue as 482 issue for U.S. sub—may be taken into account

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Other Wrinkles

• Statute of Limitations– May be different for FP– ECI v. FDAP income

• Settlement—What is the effect of resolution on 482 grounds with U.S. Sub?– Closing agreement should cover all theories– Could also factor into measurement prong

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FIN 48 and Transfer Pricing Studies

• Language in existing studies varies

– More likely than not that pricing is correct

– Proper application of Section 6662 regulations, which require reasonable application of Section 482 regulations

• Many transfer pricing studies will likely suffice because of the underlying analysis and other materials supporting management judgment, regardless of language

Fundamentally, management judgment as to the merits of the underlying tax position and the quality of the analysis, not specific verbiage used in the study, will determine whether transfer pricing

meets FIN 48 recognition and measurement requirements

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Recognition and Measurement – Technical Update

• Proposed FSP FIN 48-a• The proposed FSP eliminates the term "ultimate settlement" from FIN 48 and replaces

it with the term "effectively settled." The following three conditions must be met in order for an entity to conclude that a tax position is effectively settled:

a) The taxing authority has completed its examination procedures including all appeals and administrative reviews that the taxing authority is required or expected to perform for the tax position.

b) The enterprise does not intend to appeal or litigate any aspect of the tax position for the completed examination.

c) Based on the taxing authority's widely understood policy, the enterprise considers it highly unlikely that the taxing authority would subsequently examine or reexamine any aspect of the tax position included in the completed examination, presuming the taxing authority has full knowledge of all relevant information.

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Form 20-F: Item 17 v. 18Filing Requirements

• Item 17 requirements– Quantification of material differences between local

GAAP to US GAAP– Reconciliation of shareholders equity– Material differences must be explained

• Item 18 requirements– Reconciliation of local GAAP to US GAAP– Reconciliation of shareholders equity– All US GAAP and Regulation S-X disclosures

required

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Disclosure – Interim Periods for Outbound Organizations

FIN 48 Disclosure(Paragraph Reference)

Year of Adoption Interim Periods

Subsequent Year Interim Periods

(20) Interest and penalties policy Yes Changes to the policy

(21.a) Tabular reconciliation of unrecognized tax benefits (UTBs)

Yes Yes

(21.b) Unrecognized benefits that will, if recognized, impact effective tax rate

Yes, disclose amount as of date of adoption

Disclose material changes

(21.c) Interest and penalties in statements of operations and financial position

Yes, disclose amounts as of date of adoption


(21.d) Reasonably expected changes in the next 12 months



(21.e) Tax years open to examination in major jurisdictions

Yes Disclose material changes

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Disclosure – Year-end for Inbound Companies

FIN 48 Disclosure

(Paragraph Reference)Year of Adoption Subsequent Year

End(20) Interest and penalties policy Yes Changes to the policy

(21.a) Tabular reconciliation of unrecognized tax benefits (UTBs)

Yes Yes

(21.b) Unrecognized benefits that will, if recognized, impact effective tax rate



(21.c) Interest and penalties in statements of operations and financial position

Yes, disclose amounts as of date of adoption


(21.d) Reasonably expected changes in the next 12 months



(21.e) Tax years open to examination in major jurisdictions

Yes Disclose material changes

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Disclosure Implications of FIN 48

• Recognition/derecognition and disclosures required by FIN 48

– May provide “roadmap” to audit team

– May indicate when a team has missed an issue

– LMSB agents currently receiving FIN 48 training

• May increase the significance of Item 17 v. Item 18 filings

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Potential Privilege Implications of FIN 48

• Auditors increasingly requesting disclosure of opinions and other tax advice

• Companies may create additional documentation and analyses specifically to support the FIN 48 position

• Disclosure of attorney/tax advisor advice– Likely results in waiver of attorney-client privilege

– Cases are mixed on whether disclosure also results in waiver of work product protections

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Audit and Privilege Implications of FIN 48

• Recognition/derecognition and disclosures required by FIN 48 may provide “roadmap” to audit team, or may at least indicate when a team has missed an issue

– LMSB agents currently receiving FIN 48 training

• IRS Policy of Restraint currently limits requests for accrual workpapers, including FIN 48 materials

– Traditionally, IRS has not sought tax accrual workpapers except where taxpayers have engaged in listed transactions

– December 2006-policy of restraint confirmed in light of FIN 48

– February 2007-LMSB Commissioner Nolan indicates that IRS is reviewing the policy generally

• Even if audit teams don’t request workpapers, if an issue is litigated, the workpapers, including FIN 48 materials, will likely be requested

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2006 Form 10-K – SAB 74

– Still assessing 23%– Still assessing, do not expect adoption to be

material 10%– Do not expect adoption to be material 44%– Quantified amount/range of expected adoption

adjustment 23%

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Implementation Challenges – Time– Workplan– Resources– Documentation requirements– US vs. rest of the world– Differing auditor standards & approaches

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FIN 48 – Workplan example

1. Internal communication and education2. Formulation of implementation plan3. Identification of all significant uncertain tax positions4. Modify/develop accounting policies and processes affected by FIN 48 5. Assess and develop supporting documentation for uncertain tax positions6. Prepare draft financial statement presentation and disclosures7. Change and/or develop internal controls8. Tax planning and tax examination management9. Identify and determine appropriate resources and systems required for ongoing compliance

with FIN 48

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FIN 48 – S-O 404 implications• Establish controls and processes at both entity-level and transaction

processing level:– Proper unit of account– Identification and communication of UTPs– Probability assessment– Measurement assessments– Multiple location monitoring and communication– Communication between financial reporting, tax and other

internal functions and outside experts– Proper review and approval of key judgments and estimates

including, if necessary, review by senior management and the audit committee

– Financial statement presentation and disclosures– Automated processes and spreadsheets

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FIN 48 – Potential Future Implications

– Less flexibility in tax reserve determination– Greater income statement volatility– Need for enhancements to management’s processes and

controls over UTPs– Increased internal interaction and coordination – Increased external attention

Documents

2007 OFII Tax ConferenceAventura, FL 1 FIN 48 Applicability to Inbound Companies