FINANCIAL REPORTING FOR UNCERTAIN TAX POSITIONS

FINANCIAL REPORTING FOR UNCERTAIN TAX POSITIONSBy James R. Browne

Table of ContentsI. Introduction . . . . . . . . . . . . . . . . . . . . . . . 77II. Commonly Expressed Levels of

Confidence . . . . . . . . . . . . . . . . . . . . . . . . 78III. Existing GAAP . . . . . . . . . . . . . . . . . . . . . 79

A. FAS 5 — Accounting for Contingencies . . 79B. FAS 109 — Accounting for Income Taxes . 79C. CON 6 — Elements of Financial

Statements . . . . . . . . . . . . . . . . . . . . . . 80D. Summary of Existing GAAP . . . . . . . . . . 81

IV. The Affirmative Judgment Standard . . . . . . 81V. Technical and Policy Foundations . . . . . . . . 82

A. No Technical Foundation . . . . . . . . . . . . 82B. No Policy Foundation . . . . . . . . . . . . . . . 84

VI. Problems With the FASB Proposal . . . . . . . . 85A. Misstatement of Assets and Liabilities . . . . 86B. Mismatching of Income and Expense . . . . 86C. Inconsistent Standards for Loss

Contingencies . . . . . . . . . . . . . . . . . . . . 86D. Excessively Restrictive Standard . . . . . . . 87E. Privilege and ‘Road Map’ Issues . . . . . . . . 88F. Unasserted Claims and the ‘Audit Lottery’ . 88G. Settlements . . . . . . . . . . . . . . . . . . . . . . 89H. Convergence . . . . . . . . . . . . . . . . . . . . . 90I. Implementation Problems . . . . . . . . . . . . . 90

VII. Conclusion and Recommendations . . . . . . . 92A. ‘Invalid’ Tax Positions . . . . . . . . . . . . . . 92B. Audit Detection Risk . . . . . . . . . . . . . . . . 92

I. Introduction

On July 14, 2005, after more than a year of delibera-tions, the Financial Accounting Standards Board issuedan exposure draft of a proposed interpretation of FASBStatement No. 109, Accounting for Income Taxes (FAS 109)addressing the accounting for uncertain tax positions (theProposed Interpretation).1 The Proposed Interpretationprovides, among other things, that it must be ‘‘probable’’that a tax position will be sustained before the tax benefitof the position can be recognized in the financial state-ments.2 For that purpose, the term ‘‘probable’’ is meant tohave the same meaning as used in FASB Statement No. 5,Accounting for Contingencies (FAS 5), which means a levelof confidence less than virtually certain but higher than‘‘more likely than not.’’3 In applying the new standard,audit detection risk must not be considered.

FASB’s action follows the cue of the Securities andExchange Commission Chief Accountant’s Office. In aDecember 2003 speech, Randolph Green, a staff memberin the SEC Chief Accountant’s Office, expressed his viewthat a company should not record in its financial state-ments the tax benefit of positions claimed on the compa-ny’s tax returns unless it is at least ‘‘probable’’ that thosetax benefits will be sustained.4 Green did not cite anyauthority for his position, and none has been offered byFASB.

1FASB Exposure Draft No. 1215-001, Accounting for UncertainTax Positions — an Interpretation of FASB Statement No. 109 (July14, 2005).

2The Proposed Interpretation addresses not only the issue ofthe proper standard for initial recognition of tax benefits, butalso several collateral issues involving subsequent recognitionand derecognition, measurement, classification, changes injudgment, interest and penalties, and disclosure. Those collat-eral issues are beyond the scope of this article.

3See FASB Special Report, Application of FASB Statements 5 and114 to a Loan Portfolio (1993), Q. 8.

4R. Green, 2003 Thirty-First AICPA National Conference onCurrent SEC Developments (Dec. 11, 2003), reprinted at http://www.sec.gov/news/speech/spch121103rpg.htm#9. Mr. Greenstated:

In my view, the recognition of the gross amount of acontingent tax asset . . . should be evaluated for initialrecognition like any other asset. That is, the company andauditor should conclude that it is at least probable thededuction will be sustained and the temporary differencewill truly exist before that asset is recognized in thecompany’s financial statements.

James R. Browne is a licensed lawyer and a certifiedpublic accountant. He is a partner with the law firm ofStrasburger & Price LLP in Dallas. He was formerlychief tax executive for three large publicly tradedmultinational corporations, and was a partner in a Big4 accounting firm. The views expressed in this articledo not necessarily represent the views of any currentor former employer, firm, or client.

In this report, Browne argues that the FASB’sproposal for accounting for uncertain tax positions isunworkable and will lead to material misstatements ofan entitiy’s true tax obligations. He argues that exist-ing accounting principles reasonably balance compet-ing policy objectives and should be retained. He offerstwo recommendations for clarifying existing rules toaddress perceived abuses.

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The standard expressed by Green and FASB looks towhether it is probable that a reported tax position will besustained, and thereby adopts an ‘‘affirmative judgment’’standard. In contrast, existing accounting principles lookto whether it is probable that a reported tax position willbe disallowed, which is an ‘‘impairment’’ standard.5 Thoseare obviously opposite approaches.

It is the contention of this article that the affirmativejudgment standard proposed by FASB is unworkable andwill lead to material misstatements of tax liabilities infinancial statements. The existing impairment standardreasonably balances competing policy issues and shouldbe retained.6

II. Commonly Expressed Levels of ConfidenceBefore turning to a discussion of applicable account-

ing principles, it is helpful to have a general understand-ing of the commonly expressed levels of confidenceregarding the question whether a particular tax positionwill be sustained if challenged by the IRS.7

In general, a taxpayer will not take a position on a taxreturn unless there is at least a ‘‘reasonable basis’’ for theposition. That is the minimum level of support necessaryto avoid a penalty for negligence.8 In other cases, penaltyavoidance may require that there be at least ‘‘substantialauthority’’ for the return position,9 or that the returnposition have at least a ‘‘realistic possibility’’ of beingsustained on the merits.10 The latter standard implies at

least a one-in-three chance of being sustained,11 andsubstantial authority is generally interpreted to requireapproximately the same level of confidence.

In cases involving tax shelters (broadly defined as anyarrangement having a significant purpose of reducingtaxes),12 the taxpayer will want to conclude that thereturn position is at least ‘‘more likely than not’’ the propertax treatment, reflecting a more-than-50-percent likeli-hood that the position will be sustained on the merits.13

That is the highest level of confidence required under thecode. In fact, the tax law does not even recognize anyexpression of confidence higher than more likely thannot, and opinions that do not use those ‘‘magic words’’run the risk of failing to satisfy the penalty avoidancestandards, even when the intent is to express a higherlevel of confidence.14

Even though more likely than not is the maximumlevel of confidence required or recognized under the taxlaw, it is relatively common practice for tax counsel toopine that a position ‘‘should’’ be sustained when thelikelihood of the position being sustained is greater thanmerely more likely than not.15 Practice varies regarding‘‘should’’ level opinions, but it is generally understoodthat a ‘‘should’’ level opinion implies a likelihood ofsuccess of greater than 70 percent.16

The highest level of confidence is reached whencounsel concludes that there is no reasonable basis for theIRS to challenge the reported tax treatment. If the IRS hasissued clear guidelines for a given tax treatment and thetaxpayer has clearly complied with those guidelines, incommon practice tax counsel will conclude that theposition ‘‘will’’ be sustained. That level of opinion essen-tially implies 100 percent certainty that the reported taxposition will be sustained.

5I have borrowed the ‘‘impairment’’ and ‘‘affirmative judg-ment’’ terminology from FAS 109, para. 95. Although the termsare used in that context in a slightly different manner, theyprovide good descriptive references for the alternative positionsdiscussed in this article.

6The exposure draft of the Proposed Interpretation addressesa number of issues other than the proper standard for initialrecognition and measurement of tax benefits. My comments onthose other issues are set forth in my letter to the FASB datedSeptember 12, 2005, which is available at http://www.fasb.org/ocl/1215-001/34067.pdf.

7It is assumed for purposes of this article that other taxauthorities generally adopt similar standards as those appli-cable under the Internal Revenue Code, if they have any suchstandards at all.

8Treas. reg. section 1.6662-3(b)(1). The reasonable basis stan-dard also applies to avoidance of the substantial understate-ment penalty in nontax shelter cases where the issue is ad-equately disclosed. Section 6662(d)(2)(B)(ii). Section referencesare to the code or the regulations thereunder.

9Section 6662(d)(2)(B)(i) (applies in the case of nontax shelteritems that are not adequately disclosed). ‘‘The substantial au-thority standard is less stringent than the more likely than notstandard (the standard that is met when there is a greater than50-percent likelihood of the position being upheld), but morestringent than the reasonable basis standard as defined insection 1.6662-3(b)(3). . . . There is substantial authority for thetax treatment of an item only if the weight of the authoritiessupporting the treatment is substantial in relation to the weightof authorities supporting contrary treatment.’’ Treas. reg. section1.6662-4(d).

10A taxpayer can avoid the section 6662(b)(1) negligencepenalty regarding a position that is contrary to a revenue rulingor notice (other than a notice of proposed rulemaking), pro-vided the position has a realistic possibility of being sustained

on its merits. The realistic possibility standard also applies to taxreturn preparers under section 6694, and is the standard appli-cable to return positions under ABA Formal Opinion 85-352.

11Treas. reg. section 1.6694-2(b)(2).12Section 6662(d)(2)(C)(ii).13A taxpayer can avoid the section 6662(b)(2) substantial

underpayment penalty for the tax treatment of a tax shelter itemonly if (1) there is or was substantial authority for that treat-ment, and (2) the taxpayer reasonably believed that that treat-ment was more likely than not the proper treatment. Section6662(d)(2)(C), Treas. reg. section 1.6664-4(f). More likely than notmeans a greater-than-50-percent likelihood that the tax treat-ment of the item will be upheld if challenged by the IRS. Treas.reg. section 1.6662-4(f)(2)(i)(B)(2).

14Treas. reg. section 1.6664-4(f)(2)(i)(B)(2) (reliance on opin-ion of counsel is warranted only if the opinion ‘‘unambiguouslystates that the tax advisor concludes that there is a greater than50-percent likelihood that the tax treatment of the item will beupheld if challenged by the Internal Revenue Service’’).

15Although ‘‘should’’ is the term commonly used among taxprofessionals, the term ‘‘should’’ is a poor choice because itcould imply that a result is desirable or equitable but not legallyjustified.

16N. Batson, Second Interim Report of Neal Batson, CourtAppointed Examiner, In re Enron Corp. S.D.N.Y. (Bkr) Case No.01-16034 (AG) (Jan. 21, 2003), App. J, p. 18 n. 74, reprinted athttp://www.enron.com/corp/por/pdfs/examiner2/9551-10.pdf (Batson Report).

COMMENTARY / SPECIAL REPORT

(Footnote continued in next column.)

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In summary, ‘‘more likely than not’’ is the highest levelof confidence required or recognized for federal incometax purposes. Although higher levels of confidence areoften expressed in tax opinions, they have no recognizedeffect under the tax law.

Note that the opinions discussed above are generallyissued for the purpose of defending against challenges bythe taxing authorities, and not for the purpose of sup-porting the financial reporting of the tax positions. Al-though a should-level opinion issued for tax reportingpurposes is generally regarded as being sufficient toconclude for financial reporting purposes that it is ‘‘prob-able’’ under FAS 5 that the return position will be sus-tained on the merits,17 that is not necessarily a validassumption. See discussion below.

III. Existing GAAPThis section reviews existing rules relevant to account-

ing for uncertain tax positions to provide context for thediscussion of the Proposed Interpretation.

A. FAS 5 — Accounting for ContingenciesUnder existing generally accepted accounting prin-

ciples, an estimated loss from a loss contingency must beaccrued in the financial statements if the following con-ditions are met:

• Information available before issuance of the finan-cial statements indicates that it is probable that anasset had been impaired or a liability had beenincurred at the date of the financial statements. It isimplicit in this condition that it must be probablethat one or more future events will occur confirmingthe fact of the loss.

• The amount of loss can be reasonably estimated.18

In the case of an unasserted claim or assessment, ajudgment must first be made whether assertion of a claimis probable. If the judgment is that assertion is notprobable, then no accrual or disclosure is required underFAS 5. If the judgment is that assertion is probable,accrual and disclosure is handled in the same manner asan asserted claim.19

Disclosure is required for any loss contingency when itis probable that a material claim will be asserted, and it isreasonably possible that there will be an unfavorableoutcome for the claim. If it is not probable that the claimwill be asserted, or if the possible claim is not material, orif the chances of an unfavorable outcome are remote, nodisclosure is required.20

For purposes of FAS 5, the following definitions areadopted:

Probable. The future event or events are likely tooccur. In this context, the term ‘‘probable’’ means alevel of likelihood that is less than virtually certainbut higher than more likely than not.21

Reasonably possible. The chance of the future eventor events occurring is more than remote but lessthan likely.Remote. The chance of the future event or eventsoccurring is slight.Based on the foregoing, FAS 5 imposes a three-part

test for impairment of an asset or accrual of a liabilityregarding a loss contingency involving the potentialdisallowance of a tax return position:

1. it must be probable that the reported tax treat-ment will be challenged;2. it must be probable that the future resolution ofthe challenge will confirm that a loss has beenincurred; and3. the amount of the loss must be reasonablyestimable.Only if all of those three conditions are present is it

appropriate to record an asset impairment or liabilityunder FAS 5. Even when an asset impairment or liabilityis not recorded, the entity may be required to disclose theloss contingency.22

B. FAS 109 — Accounting for Income TaxesApplicable accounting rules require the recognition of

current and deferred tax assets and liabilities generally asfollows:23

• A current tax liability or asset is recognized for theetimated taxes payable or refundable on tax returnsfor the current year.

• A deferred tax asset or deferred tax liability isrecognized for the estimated future tax effects attrib-utable to temporary differences and carryforwards.Temporary differences relate to differences in thetiming of recognition of income and expenses forfinancial reporting purposes as compared with rec-ognition of those items for tax purposes. Deferredtax assets and liabilities are not discounted to ac-count for the time value of money.

• The measurement of deferred tax assets is reduced,if necessary, by the amount of any tax benefits that,

17Id. at n.75. See also Minutes of FASB Meeting on July 27,2004, at p. 4, reprinted at http://www.fasb.org/board_meeting_minutes/07-27-04_interpst109.pdf (it is the staff’s understand-ing that a ‘‘should’’ level tax opinion and ‘‘probable’’ level ofGAAP approximate one another); FASB Staff, Uncertain TaxPositions, memorandum to Financial Accounting Standards Ad-visory Council (Sept. 23, 2004), p. 4, reprinted at http://www.fasb.org/project/09_2004uncertaintax.pdf (‘‘probable as itis used in Statement 5 is believed to be a threshold which isconsistent with a ‘Should’ level tax opinion’’).

18FAS 5, para. 8. If the reasonable estimate of the loss is arange, and some amount within the range appears at the time tobe a better estimate than any other amount within the range,that amount should be accrued. When no amount within therange appears at the time to be a better estimate than any otheramount within the range, the minimum amount should beaccrued. FASB Interpretation No. 14, Reasonable Estimation of theAmount of a Loss — an Interpretation of FASB Statement No. 5(1976).

19FAS 5, para. 38.

20FAS 5, paras. 10, 38.21FASB Implementation Guide, Application of FASB State-

ments 5 and 114 to a Loan Portfolio (1993), Q. 8.22FAS 5, paras. 10-12.23See FAS 109, paras. 8 and 17(e).



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based on the weight of available evidence, it is morelikely than not (a likelihood of more than 50 percent)that some portion or all of the deferred tax assetswill not be realized (a ‘‘valuation allowance’’).

In determining the realizability of a deferred tax asset,primary consideration is given to evidence of the futureexistence of sufficient taxable income of the appropriatecharacter and other applicable tax attributes.24 The like-lihood of disallowance of the reported tax position is notmentioned as a factor in considering whether a valuationallowance is required.25 The potential disallowance of areported tax position appears to be dealt with exclusivelyby FAS 5.

That reading makes sense. Assuming it is more likelythan not that there will be future taxable income of theappropriate character, it may generally be assumed thatthe company will realize the future tax benefits of thedeferred tax asset. The company generally expects that itwill claim the loss carryforwards, tax basis, or otherdeferred tax assets on future tax returns, and will realizereductions in otherwise payable taxes. Any risk that thetax benefit claimed in future tax periods will be chal-lenged on audit is more properly analyzed in terms ofwhether a liability for repayment of the tax benefitsshould be accrued as prescribed in FAS 5.26

C. CON 6 — Elements of Financial Statements‘‘Assets’’ are generally defined as ‘‘probable future

economic benefits obtained or controlled by a particularentity as a result of past transactions or events.’’27 ‘‘Li-abilities’’ are defined as ‘‘probable future sacrifices ofeconomic benefits arising from present obligations of aparticular entity to transfer assets or provide services toother entities in the future as a result of past transactionsor events.’’28 For purposes of CON 6, the term ‘‘probable’’is used with its usual general meaning, rather than in aspecific accounting or technical sense (such as that in FAS5), and refers to that which can reasonably be expected orbelieved on the basis of available evidence or logic but isneither certain nor proved.29

CON 6 has been cited as authority for the propositionthat a tax benefit may not be recognized unless it is firstconcluded that it is probable that the position giving riseto the tax benefit will be sustained.30 That is an incorrectreading of CON 6.

In the case of a tax return position that results in acurrent tax benefit through the reduction in otherwisepayable taxes, there is generally no issue about whetherthe ‘‘asset’’ or ‘‘future economic benefit’’ will be realized.Under the self-assessment regime applicable to U.S.federal income taxes and most other income taxes, the taxdue and payable is the amount reported by the taxpayeron the tax return. That amount is assessed by the taxauthority with only a limited review (for example, reviewfor math errors and missing information). The tax au-thority’s substantive review is generally performed onlyafter the tax return has been processed, and the taxauthority is generally restricted from assessing and col-lecting any claimed deficiency until after it has notifiedthe taxpayer of the amount and basis for the deficiencyand provided the taxpayer with some prepayment ap-peal rights.31 Accordingly, the issue is not whether anasset should be recognized, but whether a liability shouldbe recorded for the potential deficiency that might resultfrom the postfiling audit process. FAS 5 directly governsthat issue, not CON 6.32

Similarly, if a tax return position results in a deferredtax benefit (for example, a net operating loss carryfor-ward, or tax basis in depreciable assets that creates adeductible temporary difference), assuming there is clearevidence of sufficient future taxable income of the appro-priate character to realize the benefit so that no FAS 109valuation allowance is required, there is generally noissue regarding the realizability of the deferred tax asset.In most cases, the deferred tax benefit will be claimed onfuture tax returns, and a reduction in taxes payable willbe realized. Thus, the requirements for asset recognitionunder CON 6 are clearly satisfied. The question iswhether a liability (or asset impairment) should berecorded to reflect the potential disallowance of thefuture tax benefits. Again, that question is governed byFAS 5, not CON 6.24FAS 109, paras. 21, 92-98.

25Although this proposition is not specifically expressed inFAS 109, it is apparently accepted by the FASB staff. See FASBstaff memorandum to Financial Accounting Standards AdvisoryCouncil (Sept. 23, 2004), reprinted at http://www.fasb.org/project/09_2004uncertaintax.pdf. (‘‘Additionally, the deferredtax valuation allowance only relates to the availability of futuretaxable income to realize a previously recognized deferred taxasset. The valuation allowance is not meant for adjustments tothe amount of the calculated deferred tax asset for sustainabilityuncertainty.’’)

26If the position giving rise to the deferred tax asset is likelyto be challenged and disallowed (in full or in part) before therealization of the deferred tax asset on future tax returns, it maybe appropriate to recognize the potential disallowance as anasset impairment rather than as a liability.

27FASB, Statements of Financial Accounting Concepts, StatementNo. 6 — Elements of Financial Statements para. 25 (1985) (herein-after CON 6). Statements of Financial Accounting Concepts arenot part of GAAP, but reflect broad concepts underlying GAAP.

28Id. para. 35.29CON 6, para. 25 n.18, para. 35 n.21.

30See Proposed Interpretation at v; Batson Report, supra note16, at 17 and n.71.

31The FASB Minutes, supra note 17, contain a statement thatthe potential disallowance of a tax benefit should be character-ized as ‘‘payable on demand.’’ That characterization is notconsistent with the general procedure for assessment and col-lection of income taxes.

32If the company has intentionally or inadvertently under-stated its tax liability, it is arguable that the understatementrepresents an accrued liability governed by CON 6, and not aloss contingency governed by FAS 5. In practice, the twostandards should not lead to different results. If a tax returnposition has no reasonable possibility of being sustained, bothstandards will require an accrual for the expected deficiency. Ifthe tax return position has a reasonable possibility of beingsustained, the potential understatement should be viewed ascontingent and tested under FAS 5 (which requires an accrualfor the reasonable estimate of the expected deficiency).



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The CON 6 asset recognition standard does apply withrespect to claims for tax refunds. The refund amountrepresents an asset (receivable) that will not be recog-nized unless it is probable, in the usual general meaning,that the refund will be realized (that is, granted by thetaxing authority, even if only conditionally). When thetaxing authority is likely to dispute the taxpayer’s right tothe refund before granting the refund, it may be appro-priate to treat the claim as a gain contingency in accor-dance with FAS 5, paragraph 17.

D. Summary of Existing GAAPThe applicable accounting rules discussed above lead

to the following general conclusions for most incometaxes:33

• Tax assets and liabilities must initially be recordedin accordance with the tax returns filed or to be filedby the enterprise.

• FAS 109 requires a valuation allowance for anydeferred tax asset if it is ‘‘more likely than not’’ thatany recorded tax assets will not be ‘‘realized.’’ If atax position results in an immediate (current) taxbenefit (for example, reduction in taxes otherwisecurrently payable, or a refund), it is deemed to berealized. If a tax position will result in a deferred taxasset, the valuation allowance analysis looks towhether there will be sufficient taxable income ofthe appropriate character, or other tax attributes, touse the carryforwards or other deferred tax effects.The risk that the underlying tax position will bedisallowed is generally not considered in evaluatingwhether the deferred tax benefits flowing from thattax position will be ‘‘realized.’’

• FAS 5 requires a charge to income (and a relatedasset impairment or liability accrual) for the poten-tial disallowance of a tax position if:(1) it is probable that the tax position will bechallenged;(2) it is probable that the future resolution ofthe challenge will confirm that a loss has beenincurred; and(3) the amount of the loss can be reasonablyestimated.

• FAS 5 requires that a claim for refund or credit beaccounted for as a gain contingency if the realizationof the refund or credit is subject to material uncer-tainty.

In short, under the impairment standard appliedunder existing GAAP, tax benefits are recognized in thefinancial statements in accordance with the reported taxpositions. A tax benefit is not offset by any valuationallowance unless it is more likely than not that the benefitwill not be realized, and is not offset by any loss contin-gency accrual unless it is probable that the tax benefit willbe challenged and disallowed by the tax authority.

IV. The Affirmative Judgment Standard

The Proposed Interpretation turns existing GAAP onits head and suggests that an enterprise should notrecord in its financial statements the tax benefit of aposition reported in its tax return unless it is probablethat the reported tax position will be sustained. And forthat purpose, the Proposed Interpretation requires theenterprise to assume that the position will be challengedand litigated to a final decision.34 That threshold inquiryapplies to first determine whether a tax benefit can berecognized. Once the tax benefit meets that ‘‘initial rec-ognition’’ test, the entity must then proceed to the secondstep of the analysis and ‘‘measure’’ the amount of benefitto record in the financial statements. The measurement isbased on management’s best estimate of the amount ofbenefit that will be sustained, taking into account anypotential settlement with the taxing authority. FAS 109would presumably still apply to determine whether avaluation allowance is required regarding any recog-nized deferred tax asset. FAS 5 would appear to have nocontinuing role regarding income tax loss contingencyaccruals.35

In applying the initial recognition test, the ProposedInterpretation introduces two new and highly confusingconcepts. First, the Proposed Interpretation requires adetermination of the proper ‘‘unit of account’’ to beanalyzed for initial recognition and measurement.36 Al-though the term ‘‘unit of account’’ is undefined, anillustration is given using four research projects. Theillustration states that each research project is a ‘‘unit ofaccount’’ for purposes of determining whether the re-search credit claimed by the company is ‘‘valid’’ (that is,probable of being sustained). There is no guidance pro-vided as to why each research project was a proper unitof account (as opposed to different categories of expen-ditures, for example), and the illustration cautions that‘‘the appropriate unit of account may be different basedon facts and circumstances.’’37

Second, the Proposed Interpretation draws a distinc-tion between the ‘‘validity’’ of a tax position versus the‘‘valuation’’ of items associated with the position. Anillustration is given of a charitable contribution of intan-gible property when the deduction for the contribution isclearly proper, but the value assigned by the taxpayer tothe intangible property is unlikely to be sustained.38

As noted above, audit detection risk is not taken intoaccount in determining the initial recognition or mea-surement of a tax benefit.

33These observations apply to income taxes imposed underthe code, and other income taxes imposed under a self-assessment system whereby original tax returns filed by theentity are not subject to substantive review before acceptance bythe tax authority.

34See discussion at note 82, infra.35If management cannot recognize more than its best esti-

mate of the benefit that is ‘‘probable of being sustained uponaudit’’ (paragraph 11 of the Proposed Interpretation), therecould be no circumstances under which it would be probablethat an additional loss (that is, lower tax benefit) would beincurred.

36Proposed Interpretation, paras. 9, A2.37Id. n.6.38Id. para. A13.



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As discussed below, the proposed standard cannot bejustified on either technical or policy grounds, will un-dermine the integrity of financial statements, and willlead to significant implementation problems.

V. Technical and Policy Foundations

A. No Technical FoundationNeither the Proposed Interpretation nor the publicly

available documents related to the FASB deliberations onthe Proposed Interpretation provide any indication of thetechnical basis for the proposed affirmative judgmentstandard, other than the cryptic reference to CON 6 in thesummary section of the exposure draft. However, theFASB staff and others have indicated informally that, inaddition to CON 6, existing guidance under questions 4and 17 of the FASB Implementation Guide to FAS 10939

also support the proposed standard, and that the ap-proach to recognition of regulatory assets under FAS 71(as amended by FAS 90) provides precedent for theproposed approach to recognition of tax benefits. Asdiscussed below, none of that prior guidance providessupport for the proposed standard for recognition of taxbenefits.1. CON 6 asset recognition standard. Although thesummary of the Proposed Interpretation implies that theprobable standard for initial recognition of tax benefits asset forth in paragraph 6 of the Proposed Interpretation isconsistent with the general requirements for recognitionof assets in CON 6, that is a dubious proposition forseveral reasons.

First, the definition of probable in CON 6 is differentfrom the definition of probable in FAS 5. CON 6, footnote18 provides:

Probable is used with its usual general meaning,rather than in a specific accounting or technicalsense (such as that in FASB Statement No. 5,Accounting for Contingencies, par. 3), and refers tothat which can reasonably be expected or believedon the basis of available evidence or logic but isneither certain nor proved.

FASB has clarified that the term ‘‘probable’’ as used inFAS 5 ‘‘does not mean virtually certain [but] is a higherlevel of likelihood than ‘more likely than not.’’’40 Onemight reasonably infer from that guidance that probablein the ‘‘usual general’’ meaning under CON 6 is a lowerlevel of confidence than required under FAS 5,41 and isonly a more likely than not level of confidence.42

Second, even if the definition of probable in CON 6 isthe same as the definition of probable in FAS 5 and istherefore an appropriate standard under the proposedaffirmative judgment approach, the Proposed Interpreta-tion changes the definition by restricting the assessmentof probability to a consideration that is ‘‘based solely onthe technical merits of the position.’’ Neither CON 6 norFAS 5 contains any such limitation. Considerations otherthan solely technical merits can have a significant bearingon the expected outcome of a tax controversy, and it isunclear why FASB would exclude those considerationsfrom management’s evaluation of the sustainability of atax position.43

Third, as previously discussed, it is generally inappro-priate to regard income tax benefits (other than claims forrefunds and credits) as assets under CON 6.44

For all of those reasons, CON 6 does not provide avalid technical foundation for the proposed initial recog-nition standard or for FASB’s proposed affirmative judg-ment approach.2. FAS 109 Implementation Guide — Question 4. Ques-tion 4 of the FAS 109 Implementation Guide provides asfollows:

Q — An enterprise may have a basis under the taxlaw for claiming certain deductions, such as repairexpenses on its income tax returns. However, theenterprise may have recognized a liability (includ-ing interest) for the probable disallowance of thosetax deductions that, if disallowed, would be capi-talized for tax purposes and then would be deduct-ible in later years. How should these items beconsidered if scheduling of future taxable or de-ductible differences is necessary? [17, 21]

39FASB Special Report, A Guide to Implementation of Statement109 on Accounting for Income Taxes: Questions and Answers (2001)(hereinafter FAS 109 Implementation Guide).

40See FASB Special Report, Application of FASB Statements 5and 114 to a Loan Portfolio (1993), Q.8.

41Cf. FASB Exposure Draft, Proposed Statement of FinancialAccounting Standards: Business Combinations — a Replacement ofFASB Statement No. 141 (June 30, 2005), para. 35 (a contingencyof an acquired business is recognized if the CON 6 definition ofasset or liability is met ‘‘even if that contingency does not meetthe recognition criteria in Statement 5’’).

42Most current dictionaries define the term ‘‘probable’’ asmeaning likely but not certain, and define the term ‘‘likely’’ as

meaning probable, creating a circular definition that providesno guidance as to the precise level of confidence required toestablish an item as being probable. However, Webster’s Un-abridged Dictionary (1913 edition) defines the term as ‘‘Havingmore evidence for than against . . . likely.’’ That definitionmakes more clear that probable ordinarily means more likelythan not.

43In some circumstances, considerations such as informaladministrative practice and prior settlement experience willindicate a higher level of confidence of sustaining a tax positionthan would be indicated by a consideration of only the technicalmerits of the position. In other circumstances, nontechnicalconsiderations (for example, lack of strong business purpose fora transaction, or conflict with statutory intent) will indicate alower level of confidence than the pure technical merits of theposition. Excluding these matters from consideration will leadto unreliable assessments of probability.

44Only one of the comment letters submitted in response tothe exposure draft offers any explanantion why an asset recog-nition model is appropriate. The letter presents the rathersurprising view that a tax return position essentially representsa claim against government funds. Letter of Ernst & Youngdated September 14, 2005, reprinted at http://www.fasb.org/ocl/1215-001/34598.pdf (‘‘under appropriate tax law a portionof a company’s earnings are due to the taxing authority. . . . Theability of the company to claim a portion of the amount due thegovernment is subject to recognition of the benefit of a given taxposition’’). I think few would agree with the characterization ofa tax position.




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A — Accrual of a liability for probable disallowanceof expenses, such as repairs, has the effect ofimplicitly capitalizing those expenses for tax pur-poses. Those capitalized expenses are considered toresult in deductible amounts in the later years inwhich allowable deductions (such as depreciationexpense) are expected for tax purposes. If theliability for probable disallowance is based on anoverall evaluation of various exposure areas, sched-uling should reflect the evaluations made in deter-mining the liability for probable disallowance thatwas recognized.

Upon disallowance of those expenses, taxable in-come of the year for which the expenses are disal-lowed is higher. That increase provides a source oftaxable income (paragraph 21(c)) for purposes ofassessing the need for a valuation allowance fordeductible temporary differences. Similarly, taxableincome for years after the disallowance will belower because of annual deductions attributable tothose capitalized amounts.

A deductible amount for the accrued interest isscheduled for the future year in which that interestis expected to become deductible as a result ofsettling the underlying issue(s) with the tax author-ity.

Question 4 deals with a situation in which it wasprobable that a FAS 5 loss contingency had occurred,requiring that a liability be recorded for the expected taxdeficiency. The question addressed is whether the corol-lary effects of the probable deficiency (that is, additionalincome in the year to which the deficiency relates andadditional expense in subsequent years) can be taken intoaccount in assessing whether a valuation allowance isrequired for a NOL carryforward.

Question 4 does not stand for the proposition that acurrent tax benefit cannot be recorded unless it is prob-able that the tax position will be sustained on audit.Rather, Question 4 implies the opposite: that currenttaxes are recorded based on the positions reported on thetax return, and that the question is then whether there isa FAS 5 loss contingency reserve required.3. FAS 109 Implementation Guide — Question 17.Question 17 of the FAS 109 Implementation Guide pro-vides, in part, as follows:

17. Q — In a taxable purchase business combina-tion, an enterprise allocates for tax purposes thepurchase price to the assets acquired and liabilitiesassumed so as to maximize the potential income taxbenefits from the combination. Although the enter-prise has a basis under the tax law for the alloca-tions claimed in initial filings with the tax authority,that enterprise believes that portions of the alloca-tion will be denied by the tax authority and theamount assigned to goodwill will be increased.Should deferred income taxes at the date of thebusiness combination be based on (a) the tax basisof acquired assets and liabilities as claimed in initialfilings or (b) the best estimate of the tax basis thatwill ultimately be accepted by the tax authority?What is the appropriate accounting in periods

subsequent to the business combination forchanges in the purchase price allocation for taxpurposes? [30]

A. The tax basis of an asset or liability is a questionof fact under the tax law. The tax basis of mostassets and liabilities is not subject to dispute andcan be determined from initial filings with the taxauthority. However, the tax basis of some assets andliabilities is unclear and will be determined by taxregulations, negotiations with the tax authority,appeals procedures, or, in some cases, litigation.The tax basis of those assets and liabilities may notbe appropriately determined from initial filingswith the tax authority because those filings are onlythe first step in the process to establish the tax basis.Deferred tax assets and liabilities at the date of abusiness combination should be based on manage-ment’s best estimate of the tax basis of acquiredassets and liabilities that will ultimately be acceptedby the tax authority.

The best estimate standard used in Question 17 is amuch less restrictive standard than the probable standardproposed by FASB, and is consistent with the FAS 5impairment standard. When management evaluates re-ported tax positions under FAS 5, it looks at thosepositions that are likely to be challenged on audit anddetermines a reasonable estimate of the liability to beincurred to resolve the challenge. I submit that thisanalysis is the same analysis that management willundertake to arrive at its best estimate of the tax basis ofassets and liabilities that will ultimately be accepted bythe tax authority. Accordingly, Question 17 is fully con-sistent with the impairment standard of FAS 5 and lendsno support to the probable standard proposed by FASB.

4. FAS 71/FAS 90 recognition of regulatory assets. Para-graph 9 of FASB Statement No. 71, Accounting for theEffects of Certain Types of Regulation, deals with the abilityof a regulated enterprise to record an asset for all or partof an incurred cost that would otherwise be charged toexpense (commonly referred to as a ‘‘regulatory asset’’).A regulatory asset can be recorded if, among otherrequirements, ‘‘It is probable that future revenue in anamount at least equal to the capitalized cost will resultfrom inclusion of that cost in allowable costs for rate-making purposes.’’ For that purpose, the term ‘‘prob-able’’ was originally defined in accordance ‘‘with itsusual general meaning, rather than in a specific technicalsense.’’

In contrast, paragraph 11 of FAS 71 provides, in thecase of refunds to customers ordered by the regulator,that the criteria of paragraph 8 of FAS 5 be applied indetermining whether a liability for the regulatory refund(‘‘regulatory liability’’) is required.

Subsequently, in FAS 90, Regulated Enterprises — Ac-counting for Abandonments and Disallowances of Plant Costs;an amendment of FASB Statement No. 71, FASB changed thedefinition of probable as used in FAS 71, paragraph 9(relating to regulatory assets) to mean probable as de-fined for purposes of FASB Statement No. 5. The change



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was made primarily to have a single standard for therecognition of regulatory assets and regulatory liabili-ties.45

The strict standard for recognition of regulatory assetsprovided in FAS 71/90 makes sense in the context inwhich it applies, and does not provide a proper standardfor recognition of tax benefits. In the regulatory context,the enterprise has no right to collect the regulatory assetwithout the prior approval of the regulator. In contrast,under the self-assessment system generally applicable toincome taxes, the enterprise has full authority to reduceits taxes due without prior approval of the tax adminis-trator. Accordingly, the accounting considerations for thetwo types of assets are not comparable, and FAS 71/90does not provide reasonable guidance for the recognitionof tax benefits. As noted in FAS 90, ‘‘much of theaccounting specified by Statement 71 is itself a departurefrom the accounting framework applied by nonregulatedenterprises generally.’’46

B. No Policy Foundation1. Lack of consistency. The stated impetus for FASB’sproposed standard is a lack of consistency in the appli-cation of existing accounting standards.47 The allegedlack of consistency is arguably overstated, and in anyevent is not a sufficient justification for replacing theexisting rules with entirely new rules.

While practitioners have adopted different approachesto determining the reasonable estimate of probable lossunder FAS 5, and while some have characterized theirapproaches as asset recognition models, I believe thatthose different approaches have the consistent objectiveand effect of recording a reasonable estimate, in accor-dance with FAS 5, of the loss that will be confirmed whenan uncertain tax position is resolved. When a tax positionis not supported by a sufficient level of confidence tosupport a conclusion that the tax position will be sus-tained, practitioners are reasonably consistent in accruingfor the potential disallowance of the position. The re-quired level of confidence may vary depending on thenature of the position and other applicable facts andcircumstances, and that variation is an appropriate exer-cise of judgment in view of the complexities of the taxsystem.48

Admittedly, the current rules permit enterprises toexercise judgment about their expected tax liabilities andthus may result in differences between enterprises in thereporting of similar tax issues. Those differences injudgment are a reflection of the inherent complexity ofthe tax laws, different perceptions regarding the merits ofthe positions and the expected response of affected taxauthorities, and the entity’s willingness to aggressivelydefend disputed positions. The differences are not evi-dence that the rules affording an enterprise the discretionto exercise judgment about the settlement of tax liabilitiesare invalid and should be replaced with ambiguous,arbitrary, and inflexible rules that will lead to systematicoverstatement of tax liabilities.

Moreover, even if there is inconsistency in the appli-cation of existing rules to uncertain tax positions, thatdoes not justify the Proposed Interpretation. The solutionto inconsistency is not to change the standards, but ratherto clarify and enforce them.2. Deficiencies in existing GAAP. Regardless of one’sviews on the consistency issue, it is appropriate to askwhether there is a legitimate policy reason to impose aheightened standard for recognition of tax benefits. Hasthe existing standard led to undesirable consequences,and will the Proposed Interpretation fix the problem?

It is tempting to assume that there is a problem withthe existing rules based on the highly publicized reportsthat some companies were improperly overstating earn-ings based on aggressive tax positions.49 The SEC andFASB are acutely aware of those problems, and FASB’sproposed standard seems clearly motivated by a viewthat by tightening the standards for recognition of taxbenefits, it can reduce the opportunity for overstatementsof earnings.

The problem is that FASB’s proposed standard isneither necessary nor sufficient to address the problemthat existed in Enron and other similar cases. Recall thatEnron applied a ‘‘should’’ opinion standard for therecognition of tax benefits related to the transactions incontroversy. Accordingly, FASB’s proposed standardwould not have changed Enron’s financial reporting.Moreover, while the bankruptcy examiner questioned thelegitimacy of some (but not all) of the positions taken byEnron, the financial reporting of those positions wasprimarily challenged on more fundamental grounds,including failure to properly apply the existing rules forvaluation allowances and loss contingency reserves un-der FAS 109 and FAS 5.5045FAS 90, paras. 69-71.

46FAS 90, para. 37.47Proposed Interpretation, paras. 2, B2, and B45.48For example, depending on the circumstances, it may be

quite appropriate to: (i) defer recognition of a tax positionrelating to a ‘‘listed transaction,’’ and essentially treat the item asa gain contingency, even though the company has a ‘‘shouldprevail’’ opinion supporting its tax treatment of the transaction,(ii) fully or partially reserve a tax position related to a materialtax shelter item when the enterprise is unable to reach a‘‘should-level’’ of confidence that the position will prevail, and(iii) fully recognize a tax position having only a more likely thannot level of confidence when the item arises from a company’snormal operations and is not expected to draw special scrutinyfrom the IRS. While those different situations appear to useinconsistent standards, the consistent objective is to provide areasonable estimate of the expected liability.

49See Joint Committee on Taxation, Report of Investigation ofEnron Corporation and Related Entities Regarding Federal Tax andCompensation Issues, and Policy Recommendations, vol. 1, p. 26(February 2003). In its report, the JCT staff noted that Enronengaged in some tax-motivated transactions primarily to obtainfinancial accounting benefits, and ‘‘recommends that [FASB]evaluate whether changes are warranted to the rules governingaccounting for income taxes.’’

50See, e.g., Batson Report at 37, 68, 88, and 101. In addition tofailing to properly evaluate valuation allowances and losscontingency reserves, the examiner found that Enron’s account-ing for certain transactions rested on an improper application ofbusiness combination accounting rules. In other cases, Enron


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The conclusion is that Enron violated existing account-ing rules, not that the rules are deficient.51

Only two of the comment letters submitted to FASB inresponse to the Proposed Interpretation offered anydetailed criticism of the existing standards. One letterargued that existing rules allow, or even require, financialstatements to assume that dubious tax positions will besustained.52 Obviously, that is an inaccurate view ofexisting GAAP. If a tax position has a dubious foundationor ‘‘no basis in existing tax law,’’53 existing GAAP wouldrequire that it be appropriately reserved, together withapplicable interest and penalties.

Another letter criticizes existing GAAP based on thefollowing alleged limitations: ‘‘a consistently understatedliability, a perception that aggressive tax positions wouldinappropriately be reflected in a company’s financialstatements, and disclosures that are often criticized forbeing inadequate.’’54 No evidence is cited for these con-clusions. My own experience and impression is thatentities generally release reserves when tax audits areresolved, suggesting that current rules do not consis-tently understate income tax liabilities. Moreover, even ifthe existing rules did produce some understatement ofincome tax liabilities, the degree of understatement un-der existing GAAP is significantly less than the degree ofoverstatement that will result under the Proposed Inter-pretation. And negative perceptions and disclosure short-comings (the other alleged limitations of existing GAAP)can be addressed through guidance clarifying the accrualand disclosure requirements under existing GAAP asspecifically applied to uncertain tax positions.3. Encourage tax compliance. Some have suggested thatthe Proposed Interpretation serves an important publicpolicy of encouraging compliance with existing tax laws.The argument is that ‘‘if companies knew they wererequired to meet a ‘probable’ standard before they could

incorporate a tax position into their financial statements,it would . . . reduce the incentive to buy a risky tax shelterfor the purpose of reporting more favorable financialresults.’’55

As just noted regarding the Enron situation, the prob-able standard proposed by FASB will not necessarily stoptax shelters. Even in the case of the transactions the IRSconsiders most abusive (so-called listed transactions),many of the tax positions underlying those transactionsare supported by should-level tax opinions. The account-ing for those transactions would not be affected by theProposed Interpretation. Moreover, most tax shelters arepromoted on the basis of the tax benefits of the transac-tion, not on the financial accounting benefits. Even whenaccounting benefits are important, existing accountingrules already provide that an entity cannot recognize inits financial statements the tax benefits of tax sheltertransactions that are likely to be disallowed. Accordingly,all the Proposed Interpretation will do is ensure thatmany legitimate but uncertain tax positions are derecog-nized in the same manner as illegitimate tax positions,creating no greater disincentive for one than the other.For all those reasons, the Proposed Interpretation isunlikely to accomplish the desired policy objective ofpromoting compliance with the tax laws.

But more important, those who support the ProposedInterpretation out of outrage over the tax shelter scandalsshould critically examine whether it is the proper role ofFASB and the accounting rules to fix the problems of thetax laws. I submit that the objective of the accountingrules is to faithfully report the facts regarding a compa-ny’s financial position, not to influence behavior orprotect the tax system from abuse. Those who want toaddress the tax shelter problem should focus on fixingthe tax laws and the tax enforcement mechanisms andshould not use the accounting rules as a crude proxy fortax reform.56 The accounting rules are intended to beagnostic, and when they are stretched beyond theirpurpose, the integrity of the financial statements will becompromised. As discussed below, that is exactly whatwill happen under the Proposed Interpretation.

VI. Problems With the FASB Proposal

In addition to the fact that there is no authoritativetechnical guidance or compelling policy argument tosupport FASB’s proposed affirmative judgment standard,there are also many practical problems associated with

recorded deferred tax assets when the book/tax basis differen-tial did not qualify as a temporary difference (for example,investment in a partnership). Id. at 65.

51Two of Enron’s transactions provide evidence that the realsource of the problems in the Enron case was its failure to recorda valuation allowance or loss contingency accrual in accordancewith FAS 109 and FAS 5. The two transactions, each involving acontingent liability tax shelter identified as a listed transactionin Notice 2001-17, 2001-9 IRB 730, Doc 2001-2017, 2001 TNT 13-4,were supported only by more likely than not opinions, andtherefore arguably did not meet Enron’s internal standard forrecognition of a tax benefit. Nevertheless, the examiner con-cluded that Enron’s accounting for the tax benefits of thetransactions ‘‘arguably complies with GAAP’’ apparently be-cause they were the only two transactions as to which Enronrecorded a ‘‘tax cushion.’’

52Letter from Sen. Carl Levin to the Financial AccountingStandards Board (Aug. 30, 2005), pp. 2, 3, 4, reprinted athttp://www.fasb.org/ocl/1215-001/33714.pdf (‘‘While filing atax return that relies on a dubious interpretation of the tax codemay be lawful, it defies common sense to allow auditedfinancial statements to assume such speculative tax benefits willbe sustained.’’).

53Id. at 4.54Letter of Ernst & Young dated September 14, 2005, supra

note 44, p. 3.

55Letter from Sen. Carl Levin, D-Mich., supra note 52.56The Senate Permanent Subcommittee on Investigations has

issued recommendations on the tax shelter industry. Althoughthe committee had evidence that tax shelters were sometimesused to generate financial statement earnings, it (appropriately)made no recommendation to address the problem throughchanges to the accounting rules. See Senate Permanent Subcom-mittee on Investigations, The Role of Professional Firms in the U.S.TaxShelter Industry (February2005)reprintedathttp://www.levin.senate.gov/newsroom/supporting/2005/psitaxshelterreport.021005.pdf.



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the proposed standard. By comparison, the existing im-pairment standard is a more workable approach thatprovides more meaningful financial statement informa-tion.

A. Misstatement of Assets and LiabilitiesFASB’s proposed affirmative judgment standard will

lead to misstatements of an enterprise’s assets and liabili-ties. In the case of a current tax benefit that does not meetthe probable standard for recognition, the proposedstandard requires the enterprise to accrue a liability forthe potential disallowance of tax benefit, even if theenterprise reasonably believes that it is more likely thannot that the tax benefit (or some significant portion of it)will be sustained.57 Similarly, in the case of a deferred taxbenefit (for example, stepped-up tax basis in depreciableassets) that does not meet the probable standard, theproposed standard would prevent recognition of thedeferred tax asset even if it is more likely than not that thetax basis will be sustained.

It is statistically and logically impossible that all taxpositions with a less than probable level of confidencewill all be resolved at zero benefit. Therefore, it isstatistically and logically certain that the Proposed Inter-pretation will misstate tax assets and liabilities. TwoFASB members acknowledged that fact and opposed theproposed standard.58

Existing accounting principles carefully avoid the riskof overstating tax liabilities or understating assets byrequiring that a higher threshold be met before a liabilityis accrued or an asset is impaired, and by requiring thatonly the amount reasonably estimated to be paid betaken into account. It is unclear why FASB staff and amajority of FASB decided that the deliberate overstate-ment of income tax liabilities or understatement of in-come tax assets will lead to more meaningful informationfor users of financial statements. It is submitted that theexisting FAS 5 standard leads to a more appropriate andmeaningful presentation of a company’s financial condi-tion.59

B. Mismatching of Income and ExpenseUnder the proposed standard for initial recognition of

tax benefits, the tax effects of many transactions thatoccur in period 1 will not be recorded in period 1. Rather,they will be reported potentially many years later, whenthe tax effects are settled through administrative andjudicial proceedings or expiration of the period of limi-tations on assessments.60 That will cause a severe mis-matching in the timing of recognition of income andrelated tax benefits.

It can easily take 10 years or more to resolve acompany’s tax returns for a given period. Under theProposed Interpretation, during that extended resolutionperiod the company may be carrying liabilities that it hasno expectation of ever having to pay. Tax deficiencyinterest will accrue and compound, creating a fictionaldrag on a company’s reported earnings and constantlyadding to what is already an illusory liability. How doesthat provide meaningful financial information to inves-tors who trade in the company’s stock during the periodbefore the resolution of the tax matter?

The better approach (which is reflected in FAS 5) is toinitially record the income and related tax benefits inperiod 1, and, if it is probable that those tax benefits willbe sucessfully challenged, adjust the period 1 tax effectsbased on the reasonably estimated tax benefits that willbe sustained. Although there may need to be furtheradjustments in subsequent periods, the period 1 account-ing achieves the best possible matching of income and taxexpense, and gives investors the best possible picture ofthe results of current operations and financial condi-tion.61

C. Inconsistent Standards for Loss ContingenciesUnder the proposed standard, loss contingencies re-

lated to income taxes are evaluated under an affirmativejudgment standard, while other contingencies continueto be evaluated under the traditional FAS 5 impairmentstandard. It is not clear why loss contingencies related toincome taxes should be subjected to a different stan-dard.62 The differing standards are likely to confuse users

57There is no corresponding risk that tax liabilities might beunderstated. If an entity believes it is probable that a tax benefitwill be sustained (for example, 70 percent level of confidence),but also believes it is probable that some liability will beincurred to resolve the issue without litigation (for example, theentity reasonably estimates that it will pay 30 percent of the taxbenefit as a settlement), the entity is required to reduce therecognized benefit by the amount of the expected settlementpayment.

58Proposed Interpretation, para. B46.59It is arguable that FAS 5 leads to an overstatement of assets

or understatement of liabilities because it imposes too high athreshold for recognition of loss contingencies. That issue,which is not unique to tax loss contingencies, was consideredwhen FAS 5 was adopted. The restrictive standard for recogni-tion of loss contingencies can be justified on the grounds thatexcessive loss reserves are a fertile source for future earningsmanipulation. That concern was a prominent consideration inguidance issued regarding the accrual of restructuring reserves.See EITF 94-3, Liability Recognition for Certain Employee Termina-tion Benefits and Other Costs to Exit an Activity (including CertainCosts Incurred in a Restructuring). In any event, any concern that

FAS 5 provides too lax a standard for recognition of liabilities isa matter that is not unique to income taxes and is better dealtwith as part a project on loss contingencies generally. In thatregard, FASB recently declined to deal with alleged deficienciesin the application of FAS 5 to environmental liabilities on thejustification that FAS 5 should not be reconsidered on a piece-meal basis. See http://www.fasb.org/board_meeting_minutes/03-09-05_fas5.pdf.

60Indeed, in some cases the tax benefit might never berecorded, even though there is no realistic possibility that it willever be disallowed. For example, if a return position is notchallenged on audit, but under local rules the period of limita-tions for challenging the item never closes, and if audit detec-tion risk is not a factor to be considered under the proposedstandard, does the enterprise have to leave on its books foreverthe liability for potential disallowance of the return position?

61The financial statement accruals are supported by addi-tional disclosures when there is a reasonable possibility of a lossin excess of the loss accrued. See FAS 5, para. 10.

62There are other types of loss contingencies that are similarto income tax loss contingencies insofar as the contingent


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of financial statements by adding complexity to theevaluation of an entity’s assets, liabilities, and loss con-tingencies.

FASB recently recognized the imprudence of propos-ing specific rules for specific types of loss contingencies.It rejected a request to add to its agenda a project dealingwith accrual of loss contingencies related to environmen-tal liabilities, primarily on the basis that ‘‘if the Boarddecides to reconsider Statement 5, the Board shouldreconsider all of Statement 5, not just this specific is-sue.’’63 In effect, FASB acts contrary to that belief when itproposes to adopt special rules dealing with the recogni-tion of loss contingencies related to income taxes.

D. Excessively Restrictive Standard

As a practical matter, it may be difficult or impossibleto satisfy the proposed ‘‘probable’’ standard becausecompanies may be unable to obtain legal opinions orother evidence to establish that it is probable that a taxposition will be sustained. As discussed below, existingAmerican Bar Association guidelines for issuance ofopinions regarding loss contingencies are extremely re-strictive. Moreover, there may be other reasons why alawyer would be unwilling or unable to provide asupporting opinion. Under those circumstances, the pro-posed affirmative judgment standard could lead to sub-stantiation requirements that cannot be met as a practicalmatter, further exacerbating the potential misstatement ofassets and liabilities under FASB’s proposed standard.

1. ABA policy statement regarding opinions on finan-cial reporting for loss contingencies. In assessing acompany’s financial accounting for loss contingencies,the independent auditor generally will have the com-pany send a letter of inquiry to its lawyers requestingthat the lawyer furnish information to the auditor regard-ing pending or threatened litigation, and regarding cer-tain unasserted claims or assessments, that the lawyer ishandling for the client.64 The standard letter of inquiryasks the lawyer to provide, in addition to other matters,‘‘an evaluation of the likelihood of an unfavorable out-come and an estimate, if one can be made, of the amountor range of potential loss.’’65 This information is obvi-ously tied directly to the standards for reporting losscontingencies under FAS 5.

The ABA, in consultation with the American Instituteof Certified Public Accountants, adopted a policy ofgenerally refraining from providing auditors an evalua-tion of the likelihood of an unfavorable outcome regard-ing loss contingencies ‘‘except in those relatively fewclear cases where it appears to the lawyer that an

unfavorable outcome is either ‘probable’ or ‘remote’.’’66

For those purposes, an unfavorable outcome is ‘‘prob-able’’ if the outcome is ‘‘reasonably certain’’ (that is, thechances of the client prevailing appear slight and of theclaimant losing appear extremely doubtful).

The commentary on the ABA policy notes that lawyersgenerally cannot provide any statement about the prob-ability of outcome of litigation in any measurable sense.Accordingly, it is a rare case in which a lawyer could givean opinion on whether a favorable outcome was prob-able. ‘‘Normally, this would entail the ability to make anunqualified judgment, taking into account all relevantfactors which may affect the outcome, that the client mayconfidently expect to prevail on a motion for summaryjudgment on all issues due to the clarity of the facts andthe law.’’67

Thus, the ABA policy explicitly disclaims statementsof probability in any numerical sense, and seems to usethe term ‘‘probable’’ to indicate a level of confidenceclosely approaching absolute certainty. If that interpreta-tion is applied in the context of FASB’s proposed stan-dard for recognition of tax benefits, there will be far moreinstances in which tax benefits are not recorded (orreserved) that FASB seems to be contemplating.2. The ‘should prevail’ opinion safe harbor. In anapparent attempt to avoid the ABA’s restrictive interpre-tation of the term ‘‘probable’’ as used in FAS 5 in thecontext of loss contingencies generally, the ProposedInterpretation provides several examples of the type ofevidence that ‘‘may,’’ in the absence of opposing evidencedemonstrate a probable level of confidence. One exampleis ‘‘An unqualified should prevail tax opinion from aqualified expert for which all conditions are objectivelyverifiable.’’ Although this appears to get around theABA’s restrictive interpretation of probable as used inFAS 5, there are several problems with that provision.

As noted above, the specific requirements for ashould-level tax opinion are not well defined, and are notnecessarily consistent among tax practitioners. Accord-ingly, the adoption of that ambiguous standard is some-what at odds with the stated objective of consistency. It isclearly at odds with any objective of simplicity andadministrability.

More important, the requirement that the opinion be‘‘unqualified’’ and that ‘‘all conditions are objectivelyverifiable’’ could invalidate an enterprise’s reliance onmany common types of tax opinions. Tax opinions arealways qualified by various matters. Moreover, criticalissues underlying many tax opinions are often based onfactual representations from the client that may not beobjectively verifiable. Accordingly, one questionswhether a tax opinion could ever meet the evidentiaryrequirement of the Proposed Interpretation.68

liability arises from the potential adjustment of a self-assessedliability. The most obvious comparable contingent liability is theliability for audit adjustments related to transactional taxes andexcise taxes.

63See http://www.fasb.org/board_meeting_minutes/03-09-05_fas5.pdf, at 5.

64AICPA, U.S. Auditing Standards, AU Section 337.08.65Id. at AU Section 337A.

66ABA, Statement of Policy Regarding Lawyers’ Responses toAuditors’ Requests for Information, para. 5 (2003) (hereinafter ABApolicy).

67Id. at 16.68See J. Gamino, ‘‘Interesting Times Coming: Grappling With

the Financial Reporting of Uncertain Tax Positions,’’ Tax Notes,


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3. Other limitations. There are many issues as to whichthe law is sufficiently uncertain (or lacking) to permit thetaxpayer or its counsel to render any conclusion regard-ing the likely outcome of an issue if it were challenged onaudit.69 There may be no reason to believe that theposition will be challenged on audit or that any suchchallenge will be sustained, but there may also be insuf-ficient legal authority to reach a conclusion that thetaxpayer ‘‘should prevail’’ on the position if the matterwere challenged and litigated to a final decision. Accord-ing to the proposed standard, the company might berequired to reserve the entire benefit of the reported taxposition until the matter is ‘‘untimately resolved,’’ poten-tially many years later.

E. Privilege and ‘Road Map’ IssuesWhen a should prevail opinion can be obtained, the

opinion might not be privileged.70 If privilege does notapply, tax authorities will have ready access to thoseopinions. Because the analysis supporting the opinionwill necessarily detail potential challenges to the compa-ny’s reported tax position, the opinion will provide a‘‘road map’’ to tax authorities of the arguments they canraise. While the opinion may conclude that those chal-lenges should not be sustained by a court, the opinion’sconclusions are not binding on the tax authority or acourt and therefore will not preclude the tax authorityfrom taking a contrary position.

The road map issue will arise even when an opinioncannot be obtained and the entity is unable to recognizein the financial statements a tax benefit claimed in the taxreturn. In those cases, the unrecognized tax benefit maybe evident from the financial statements and footnotes, orfrom supporting workpapers.71 Tax authorities will beencouraged to challenge all those positions.

While there are admittedly privilege and road mapissues under the current rules, they are less pervasivethan would be the case under the Proposed Interpreta-tion. In general, the higher the threshold for recognitionof tax benefits, the greater the number of tax positionsthat will not be recognized in the financial statements, the

greater the level of documentation that will be requiredto support the tax positions that are recognized in the taxreturn, and the greater the risk of companies involun-tarily providing tax authorities ammunition for disputes.

F. Unasserted Claims and the ‘Audit Lottery’A particularly troublesome change that would be

effected by the Proposed Interpretation is the eliminationof audit detection risk as a consideration in determiningtax reserves. Under existing GAAP, a contingent liabilityrelated to an unasserted claim is recognized only if it isprobable that that liability will be asserted, and the otherrequirements of FAS 5 are met.72 In contrast, the Pro-posed Standard states: ‘‘In assessing the probability [thata tax position will be sustained], it shall be presumed thatthe tax position will be examined by the relevant taxingauthority.’’73 That presumption is unrealistic and willsignificantly exacerbate the misstatement of a company’sexpected tax liabilities.

There may be tax positions in an entity’s tax return asto which the entity is unable to conclude that it isprobable that the position will be sustained if challenged,but as to which the entity has a fairly high level ofconfidence will never be challenged, either because theissue will not be detected, or because the taxing authorityis unlikely as a matter of administrative practice tochallenge the entity’s tax position even if the tax positionis detected on audit. The entity should not be required toaccrue a liability for those contingencies because there isno reasonable expectation that the entity will ever suffera reduction in assets regarding the contingency. That isthe obvious and logical conclusion of FAS 5, but is not theresult under the Proposed Interpretation.

That problem is particularly acute as applied to taxpositions as to which there is no applicable statute oflimitations. Normally, a tax benefit that has not beenrecognized initially and is not detected on audit will berecognized when the period of limitations for challengingthe position lapses.74 However, if the position relates toan issue whether the entity has tax ‘‘nexus’’ in a particu-lar taxing jurisdiction, the entity may not have filed a taxreturn with the applicable taxing authority and thereforethe period of limitations may never lapse.75 At somepoint it will become clear that the issue will never beraised by the taxing authority and that the potentialliability is zero, but if audit detection risk is not a relevantconsideration for recognition of a tax benefit, the entitywould apparently be required to maintain a perpetualliability for the potential disallowance of the tax benefit,including unending quarterly accruals for associatedinterest and penalties. It is not clear how that providesmore meaningful financial information to users of finan-cial statements.

Sept. 12, 2005, p. 1289 at 1291 (noting inconsistently of ‘‘unquali-fied should’’ description, and uncertainty regarding the mean-ing of ‘‘all facts are objectively verifiable’’).

69One need not venture to third-world countries to find thoseexamples. In the state income tax arena, the unitary businessprinciple, the nonbusiness income concept, and nexus determi-nations are so ambiguous as to defy, in many situations, anyreliable forecasts as to the probable outcome of litigation onsuch issues.

70First Federal Sav. Bank of Hegewisch v. United States, No.93-162C (Fed. Cl. Feb. 12, 2003) (disclosure of legal opinions toexternal auditors as part of auditor’s routine review of boardminutes in connection with performance of annual audit con-stituted a waiver of attorney-client privilege).

71While tax accrual workpapers are not routinely requestedby the IRS, there are no legal limitations on a tax authority’sright to request and receive the workpapers. See, e.g., Announce-ment 2002-63, 2002-27 IRB 72, Doc 2002-14466, 2002 TNT 117-12(IRS will request tax accrual workpapers only in unusualcircumstances, except in cases involving tax shelter transac-tions).

72FAS 5, paras. 10, 38.73Proposed Interpretation, para. 7.74Proposed Interpretation, para. 8.75See, e.g., Tex. Tax Code Ann. section 111.205(a)(2). Note that

there are tax positions other than nexus issues for which thestatute of limitations will never lapse. See Tex. Tax Code Ann.section 111.205(a)(3) (no period of limitation on assessment oftax underpayment of 25 percent or more).



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That problem exists even when the contingency is nottied to audit detection risk. Some tax accounting conven-tions are routinely sustained on audit as a matter ofadministrative convenience or materiality even though itmight be impossible to conclude that it is probable thatthe reported tax treatment would be sustained if thematter were litigated.76 In those cases, the proposed FASBstandard would require the accrual of a liability eventhough it is highly unlikely that the liability will ever bepaid.

In explaining the basis for treating income tax contin-gencies different from other loss contingencies, one FASBmember noted in the discussion at the February 15, 2005,meeting that an income tax liability is not like a patentinfringement claim (the example used in paragraph 38 ofFAS 5) because income tax liabilities must be reported ona tax return.77 There are several reasons why that distinc-tion is invalid.

First, it is not clear that the entity in the patentinfringement example didn’t report its patent usage tothe U.S. patent office or in some other public forum. So itis questionable whether one can reliably conclude thatthe treatment under FAS 5 is conditioned on the potentialliability not being reported.

Second, there are numerous other categories of con-tingent liabilities that are reported in some manner to thepersons that may be in a position to assert a claim againstthe company, yet there is no indication that those situa-tions require special treatment under FAS 5. An obviousand directly analogous example is sales taxes and othertransaction taxes. Similarly, government contracts fre-quently require extensive reporting and are subject toaudit. Employee benefit plans also involve extensivereporting to employees, which can lead to claims againstthe plan sponsor.78 Must entities now assume that in all

cases all potential claims related to ‘‘reported’’ items willinevitably be raised regardless of the actual likelihood ofthose claims?

Third, it is not true that all tax positions must bereported on a tax return. A common example is tax nexus.If the entity takes the position that its activities in aparticular jurisdiction are not subject to tax (that is, thecompany does not have tax nexus in the jurisdiction), itwill not file a tax return. What is the logic for requiring anentity to assume in all cases that those positions will beaudited? Should tax positions that are not reported on atax return be subject to a different standard?

What the foregoing discussion demonstrates is thatone cannot validly state that income taxes are somehowunlike any other class of loss contingency and that auditdetection risk should never be taken into account inaccounting for uncertain tax positions.

G. SettlementsMany, if not most, uncertain tax positions will be

resolved through compromise (settlement) with the taxauthority rather than through litigation or through a fullconcession of the issue by the taxpayer or the taxauthority. Although those settlements are common, it isunclear how they are to be taken into account under theProposed Interpretation.

The Proposed Interpretation provides that a tax posi-tion is initially recognized only if it is ‘‘probable of beingsustained on audit by taxing authorities based solely on thetechnical merits of the position.’’79 In contrast, one of theexamples illustrating the operation of this rule restatesthe rule as ‘‘probable of being sustained on audit (includ-ing settlement of appeals or litigation) under the relevant taxlaw.’’80 Those two different articulations of the initialrecognition standard make it unclear how settlementconsiderations are taken into account in the initial recog-nition analysis. If a tax position involving solely thevalidity of a deduction has only a 50 percent chance ofbeing sustained in litigation, but the entity can establishthat there is a greater than 70 percent probability that thematter can be settled with the tax authority on a basisallowing 40 percent of the reported tax benefit, whatamount is recognized in the financial statements? Is itzero, or is it 40 percent?

The answer appears to be zero. The Proposed Inter-pretation notes that a significant difference between thebenefit to be recognized in the financial statements andthe reported tax position is evidence that the probablethreshold has not been met.81 Also, the minutes of theFASB meetings on the exposure draft indicate that initialrecognition analysis is based on the expected outcome ifthe position ‘‘was contested all the way through the court

76An example is the expensing of asset acquisition costsbelow a specified threshold. For book purposes, many entitiesexpense certain asset acquisition costs below a specified amount(for example, $1,000). Although the technically proper account-ing is to capitalize and depreciate the costs, the amounts are notmaterial to the financial statements, and the administrativeinconvenience and cost associated with capitalizing and depre-ciating the assets outweigh the benefits. The entity may followthe book expensing convention in filing tax returns, and as amatter of administrative practice, the taxing authority may haveinformally agreed that it will not challenge the entity’s taxtreatment of those costs. Despite the taxing authority’s admin-istrative practice, the entity may not be able to conclude that itis probable that it would prevail in its tax treatment of the costsif the matter were litigated.

Other examples might include tax positions based on infor-mal agreements with the IRS, such as carryforward effects ofaudit settlements and rollbacks of advance pricing agreements.Competent authority relief would be another example of a taxbenefit that might be undisputed and reasonably expected, butclearly not probable as a purely technical matter.

77This discussion is apparently the basis for the statement inparagraph B14 that ‘‘the Board does not believe that guidance isapplicable to tax positions because a tax return is generallyrequired to be filed.’’

78See, e.g., ‘‘Citigroup Faces Lawsuit Over Its Pension Plan,’’The Wall Street Journal Online, Feb. 7, 2005, reporting on a lawsuit

filed against Citigroup alleging an illegal benefit formula underCitigroup’s cash balance pension plan, and noting ‘‘roughly 20or so lawsuits against cash balance pension plans.’’ Citigroup’spreviously published financial statements make no mention ofthat potential lawsuit, presumably because the company did notbelieve it was probable that such a claim would be asserted.

79Proposed Interpretation, para. 6.80Id. at para. A3.81Id. at para. 9.




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system.’’82 That statement suggests that the potentialsettlement of the dispute with the tax authority is not aconsideration when evaluating a position for initial rec-ognition, and is relevant in measuring the best estimateof the position only once it meets the initial recognitionthreshold.83 At a minimum, it appears that an expectedsettlement below 70 percent of the reported tax benefitwould be evidence that the probable recognition thresh-old has not been met.

Under the Proposed Interpretation, if the probablerecognition threshold is not met initially, the tax positionis subsequently recognized in the interim period in whichthe threshold is met, the matter is ‘‘ultimately resolved’’with the tax authority, or the statute of limitationslapses.84 That raises a question whether a nonbindingsettlement with the tax authority causes the matter to be‘‘ultimately resolved’’ so that the tax benefit allowedunder the settlement can be recognized at the time thesettlement is reached.

It is not uncommon for an audit to be concludedwithout a binding final determination of the taxpayer’sliability for the period audited. The audit might closewithout any action by the taxing authority (a ‘‘nochange’’ audit). Or the entity might agree to proposedaudit changes by simply signing a waiver of the restric-tions on assessment and collection of any tax due (forexample, IRS Form 870) without entering into a formalclosing agreement that precludes additional assessments.In those cases, is the matter ‘‘ultimately resolved’’ whenthe audit closes, or must the entity defer recognition ofthe previously unrecognized tax benefits allowed underthe audit until the applicable statute of limitationslapses?

It appears that the Proposed Interpretation woulddefer recognition of the tax benefit. The Proposed Inter-pretation’s presumption that tax positions will be exam-ined, without regard to the probability of such an exami-nation,85 suggests by analogy that the entity mustpresume that settled issues will be reopened as long as afurther assessment is not legally foreclosed, even if thelikelihood of the settled issue being reconsidered isremote.

Settlements are a critical component of the tax assess-ment process, and agreements reached with tax authori-ties, even if not legally binding, are often reliable evi-dence of the proper measure of an entity’s tax liabilities.It appears that the Proposed Interpretation ignores ex-pected settlements except when the settlement consti-

tutes a legally binding resolution of the matter. By failingto take expected settlements into account initially, recog-nized tax benefits will be systematically understatedrelative to the reasonably expected benefits. And bydeferring recognition of settlements until there is a le-gally binding resolution, tax benefits could remain un-recognized longer than is appropriate. Current account-ing principles avoid both of those problems by givingmanagement discretion to reasonably estimate the ex-pected outcome of tax disputes taking into account thenormal settlement process and reasonably expected ad-ministrative practice. That is the same judgment affordedto management in accounting for other disputes underFAS 5.

H. ConvergenceThe International Accounting Standards Board (IASB)

staff recently issued a paper responding to the ProposedInterpretation in connection with the IASB and FASBjoint ‘‘convergence’’ project aimed at harmonizing theinternational financial reporting standards (IFRS) forincome taxes with the U.S. generally accepted accountingprinciples.86 The IASB staff rejected FASB’s affirmativejudgment approach (which the IASB staff characterizedas a contingent gain approach).87 It instead concludedthat any uncertainty over filed tax positions is regardedas giving rise to a ‘‘stand ready liability’’ to pay addi-tional tax, and that the liability should be recognized andmeasured in accordance with IASB’s proposed amend-ments to IAS 37, Non-financial Liabilities,88 IASB’s coun-terpart to FAS 5. Under IAS 37, the stand ready liabilitywould be recognized at the amount that the entity wouldpay to settle the liability or to transfer it to a third party.That amount is generally determined based on the prob-ability weighted expected cash flows taking into accountrisks and uncertainties (other than audit detection risk).89

I. Implementation Problems1. Interpretation. One need only reference the consider-able lack of clarity in FASB’s discussion of the ProposedInterpretation at the February 16 board meeting90 tounderstand the complexity and confusion associatedwith the Proposed Interpretation. Fine distinctions be-tween the ‘‘nature’’ of a deduction or ‘‘amount’’ of adeduction, or between the ‘‘validity’’ of a deduction or

82Minutes of FASB meeting on November 17, 2004, at pp. 4-5,reprinted at http://www.fasb.org/board_meeting_minutes/11-17-04_UTP.pdf.

83The Proposed Interpretation also provides that issues mustbe evaluated individually ‘‘without consideration of the possi-bility of offset or aggregation with other positions.’’ ProposedInterpretation, para. 7. That prohibition against taking intoconsideration the trading of issues that frequently occurs insettlements of cases with multiple disputed issues implies thatthe potential settlement of a tax position is not evidence oflikelihood that the position will be sustained.

84Proposed Interpretation, para. 8.85Id. at para. 7.

86IASB Staff Paper, Short-term convergence: Income taxes —uncertain tax positions (Agenda Paper 9a), reprinted at http://www.iasb.org/uploaded_files/documents/8_1134_0509ob09a.pdf.

87Id. at para. 22-23.88See http://www.iasb.org/uploaded_files/documents/

8_38_EDAmendments!AS37IAS19(complete).pdf.89IAS 37 generally requires discounting of the expected

future cash flows, and allows consideration of the risk of claimsbeing asserted. IAS 37, paras. 33, 38. Although not mentioned inthe IASB staff paper. I understand that the IASB has determinedthat discounting is not required for income tax liabilities (whichmakes sense given that interest is generally imposed on defi-ciencies) and that audit detection risk should not be taken intoconsideration in estimating settlement value.

90See http://www.fasb.org/board_meeting_minutes/02-16-05_utp.pdf, at pp. 9-12.



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the ‘‘measurement’’ or ‘‘valuation’’ of a deduction, willlead to confusion in application. And concepts such as‘‘unit of account’’ and ‘‘bifurcated gain contingency’’have no definition and will inevitably produce confusionand inconsistencies in practice.

Consider one very simple example that highlights thecomplexity of the Proposed Interpretation. Assume acompany suffers a deductible loss from the decline inmarket value of an investment. A conservative estimateof the loss based on stock exchange price quotations is$100. It is probable that this amount of loss will besustained. However, the company claims a loss of $180on the tax return, based on the view that the quoted valueshould be reduced by an $80 minority discount. It is notprobable that the additional $80 deduction will be sus-tained, but the company expects that it can resolve thematter by agreeing to a loss of $140 ($40 of the lossclaimed on the tax return will be disallowed).

Question: What amount of tax benefit should berecorded in the financial statements regarding the stockloss?

Under one theory, zero loss would be recognized inthe financial statements because it is not probable that the$180 loss claimed on the tax return would be sustained.That harsh result might be avoided if the loss is bifur-cated into two ‘‘units of account.’’ The first unit ofaccount is the $100 loss that is probable of being sus-tained, and the second unit of account is the additional$80 loss attributable to the minority discount theory.Under that theory, the tax benefit of only the $100 loss isrecognized. Apparently, both of those answers are wrong.The correct answer, according to informal discussionswith FASB staff, is that the financial statements shouldrecognize the tax benefit of the $140 loss expected to besustained in settlement because it is probable that thecompany has sustained a ‘‘valid’’ loss, and the only issueis the ‘‘value’’ of the loss.

Compare the analysis under existing GAAP: Initiallyrecord the benefit of $180 in accordance with the taxreturn, then reserve $40 for the expected tax deficiency tobe incurred to resolve the matter with the IRS. Thatanalysis is straightforward and doesn’t turn on obscuredistinctions between ‘‘units of account’’ or ‘‘validity’’versus ‘‘value.’’

With more complicated fact patterns common in ac-tual practice, one can easily see the significant potentialfor confusion and inconsistency under the ProposedInterpretation, and how those concerns are avoided un-der the current rules.2. Documentation. The interpretational problems associ-ated with the Proposed Interpretation are magnified bythe fact that the Proposed Interpretation has an un-bounded scope. The exposure draft title suggests that itapplies only to ‘‘uncertain’’ tax positions, but its termsapply to ‘‘all tax positions accounted for in accordancewith FAS 109,’’91 which means all income tax positionswithout regard to the level of uncertainty associated withthose positions. As a result, entities will be saddled withan enormous compliance burden as they are forced to

document each quarter that each and every tax positionclaimed for the thousands of taxing jurisdictionsthroughout the world in which the entities might operatemeets the probable recognition threshold and has beenrecorded in the financial statements at the best estimateof the amount that is probable of being sustained.

Under existing GAAP, tax return positions are pre-sumed to be correct unless there is reason to believe thatit is probable that one or more positions will be chal-lenged. In that manner, the provision workpapers and taxreturns, together with the documentation of internalcontrols supporting those items, are generally sufficientdocumentation to support the financial statement effectsof tax positions. Additional documentation is requiredonly be exception, not by rule. Existing GAAP is a moresensible and practical approach.3. Application. Another significant trouble spot in theProposed Interpretation is the concept of ‘‘not recogniz-ing’’ in the financial statements tax benefits reported onthe tax return. That sounds simple, but it isn’t.

One problem is measurement. How does an entity‘‘not recognize’’ the tax benefit of a position that atransaction does not give rise to taxable income? Thatsituation comes up frequently in the transfer pricing area,in which entities may not be able to obtain a probablelevel of confidence that the IRS will not impute incomeregarding transactions with related parties.92 In thosesituations, does the entity accrue a liability for themaximum amount of tax liability that the taxing author-ity might reasonably propose? What if the tax authorityproposes a patently absurd tax deficiency based on ahighly inflated valuation of the consideration in thetransaction?93 Is the entity required to accrue a liabilityfor the proposed adjustment, or is some lesser accrualappropriate and how should that amount be determined?The Proposed Interpretation offers no guidance on theseissues, and it is difficult to see how the affirmativejudgment approach of the Proposed Interpretation can belogically applied to income exclusion situations.94 Incontrast, under existing GAAP, the entity would simplyaccrue a liability for the loss that it reasonably estimateswill be incurred to resolve the issue.

91Proposed Interpretation, para. 4.

92See, e.g., DHL Corp. v. Commissioner, 285 F.3d 1210, Doc2002-8946, 2002 TNT 72-9 (9th Cir. 2002). In that case, thetaxpayer did not report any royalty income from a trademarkthat it owned and was used by a foreign affiliate. The IRSasserted that the taxpayer should be charged with imputedroyalty income. While valuation was an issue in the case, theprimary issue was whether there was a taxable transfer of value.

93In the DHL case cited in the previous footnote, the IRSnotice of deficiency asserted a deficiency based on a trademarkvaluation of $600 million, whereas the court determined that thevalue was only $100 million. The IRS conceded at trial that thevaluation used in the notice of deficiency was invalid. T.C.Memo. 1998-461, 76 T.C.M. (CCH) 1122, Doc 99-739, 98 TNT251-12.

94Even in the case of deduction disputes, the entity may haveno way of knowing whether the tax authority will challenge thevalidity of the deduction, or will simply challenge the amount(value) of the deduction. In those cases, it is unclear whatamount of tax benefit should be ‘‘not recognized’’ by the entity.



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The other problem is tracking. If a tax deduction notmeeting the initial recognition threshold is claimed onthe tax return and produces a NOL carryforward, underthe theory of the Proposed Interpretation the companywill not record the deferred tax asset associated with theNOL carryforward. Instead, the company will accountfor the deduction as if it wasn’t claimed on the tax returnand as if the NOL carryforward doesn’t exist. As aconsequence, investors and other users of the financialstatements will not see any deferred tax asset in thefinancial statements and may wonder why the companyis not paying cash taxes in the current and future periods.Even the company may have trouble reconciling itsfinancial statements if it is dealing with thousands of taxreturns spanning 10 or more tax years, when any onereturn could have multiple uncertain tax positions thatneed to be taken into account in reconciling the taxreturns to the financial statements.

It is likely that ‘‘not recognizing’’ tax benefits (that is,breaking the audit trail from the tax return to thefinancial statements) will cause more confusion anderrors in practice than existing GAAP, and will not aid inthe goal of transparency. The current practice for mea-suring and tracking loss contingencies is a better ap-proach.

VII. Conclusion and RecommendationsThe correct and preferable approach to financial re-

porting for uncertain tax positions is the impairmentapproach applied under existing GAAP as describedabove. The affirmative judgment approach of the Pro-posed Interpretation has no technical or policy founda-tion, would undermine the integrity of financial state-ments, and would present significant implementationproblems.

While I propose retaining existing GAAP, I believethat there are some clarifications of existing GAAP thatcould be made to confirm existing practice and mitigateany concerns regarding the potential overstatement of taxliabilities.

A. ‘Invalid’ Tax PositionsConcerns about overstatement of tax benefits related

to aggressive tax positions can be effectively addressedby invoking a presumption that any tax position lacking

a more likely than not level of confidence should be fullyreserved under FAS 595 if it is probable that the positionwill be challenged on audit.96 The presumption could beovercome only if, based on all available evidence, theentity can establish that it is probable that the matter willbe resolved (for example, through settlement) for someamount less than the amount otherwise required to bereserved, and the entity can reasonably estimate theliability that will be incurred to resolve the matter. Ibelieve that such a presumption (with a more likely thannot level of confidence) would be consistent with com-mon practice because I believe that most entities assumethat a material position lacking a more likely than notlevel of confidence will generally result in a concession ofthe issue by the taxpayer. The presumption is rebuttablebecause there may be circumstances in which a fullconcession is clearly not a reasonable estimate of theexpected outcome.

B. Audit Detection Risk

If FASB is concerned that entities are deliberatelyoverstating tax benefits based on unrealistic assumptionsregarding audit detection risk, I suggest that rather thanadopting an absolute rule that unrealistically assumesthat all tax positions will be examined and challenged,FASB might consider a rebuttable presumption regardingthe detection of positions taken on tax returns. Under theproposed rebuttable presumption, an entity must pre-sume that all material tax positions taken or to be takenon a tax return will be examined by the tax authority andwill be challenged by the tax authority if there is areasonable basis for such a challenge. That presumptioncould be overcome only if, based on all available evi-dence, the entity could establish that the risk of such achallenge is remote. Again, I believe that such a rebut-table presumption would be consistent with generalpractice under existing accounting principles.

95The reserve would be based on the tax results under theposition or positions that are most likely to be asserted by thetax authority.

96See VII.B. for a proposed change in the treatment of auditdetection risk.



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FINANCIAL REPORTING FOR UNCERTAIN TAX POSITIONS

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