Uncertain tax positions: recognition and measurement

• Apply the more-likely-than-not recognition test and its examination presumption
• Measure a recognized position using cumulative probabilities
• Account for interest, penalties and classification of the liability
• Determine when a position is later recognized or derecognized

Scope

FASB Interpretation No. 48, now in ASC 740-10, applies to every tax position, not only aggressive ones. A tax position includes a deduction or credit claimed, a decision not to file in a jurisdiction, a characterization of income, and a decision to treat an entity as tax exempt. The unit of account (paragraph 5) is a judgment based on how the entity prepares and supports its return and how the taxing authority is expected to approach an examination.

Step 1: recognition

Interpretation 48 paragraph 6 requires recognition of a position's benefit only when it is more likely than not, based on the technical merits, that the position will be sustained upon examination, including appeals and litigation. More likely than not means a likelihood of more than 50 percent.

Paragraph 7 sets three rules for that assessment:

• Presume the position will be examined by a taxing authority with full knowledge of all relevant information. Detection risk is ignored.
• Technical merits come from tax law sources: statutes, legislative intent, regulations, rulings and case law. Widely understood administrative practices of the authority count.
• Evaluate each position on its own, without offset or aggregation with other positions.

Step 2: measurement

Paragraph 8 measures a recognized position at the largest amount of benefit that is greater than 50 percent likely of being realized on ultimate settlement. Management lists possible outcomes and their probabilities, accumulates the probabilities from the largest benefit down, and stops at the first amount where the cumulative probability exceeds 50 percent. Interpretation 48's own illustration (paragraph A21) recognizes $60 of a $100 position because the cumulative probability first passes 50 percent at $60.

The difference between the benefit claimed on the return and the benefit recognized is an unrecognized tax benefit. It is recorded as a liability, or as a reduction of a loss carryforward or refund receivable.

Interest, penalties and classification

• Interest (paragraph 15) starts in the first period it would accrue under the tax law, computed at the statutory rate on the difference between the position recognized and the position taken.
• Penalties (paragraph 16) are accrued when the position does not meet the minimum statutory threshold to avoid them.
• Presentation (paragraph 19): interest may be classified as income tax or interest expense, and penalties as income tax or another expense, by policy election applied consistently.
• Balance sheet (paragraph 17): the liability is current only to the extent cash payment is expected within one year or the operating cycle. It is not combined with deferred tax liabilities or assets.

Later changes

Under paragraph 10, an unrecognized position becomes recognized in the first interim period in which the threshold is met, the matter is settled, or the statute of limitations expires. Paragraph 11 requires derecognition in the first period it is no longer more likely than not to be sustained, and a valuation allowance is not a permitted substitute. Paragraph 12 requires changes in judgment to come from new information, not a reinterpretation of old facts. Paragraph 13 treats a change in judgment on a prior annual period's position as a discrete item.

Audit focus

The UTP standard page and the worked example guide go deeper. In the file, look for an inventory of positions, a technical analysis for each, the probability table for each measured position, an interest computation, and a rollforward that ties to the balance sheet.

Measuring a research credit claim at Talon Avionics Corp.