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The Two-Step Process for Recognizing Uncertain Tax Positions

November 28, 2023
The Two-Step Process for Recognizing Uncertain Tax Positions

Uncertain tax positions are tax positions an entity takes on its tax return that don’t meet the more-likely-than-not standard, meaning there is a 50% or less likelihood that the position will ultimately be sustained if challenged by the taxing authority. Below, we outline the criteria for recognizing and measuring the benefits of an uncertain tax position when calculating your ASC 740 income tax provision.

What is the basic threshold for recognition of an uncertain tax position?

The first step for evaluating uncertain tax positions is the recognition step. Generally, the tax benefits associated with a tax position may be recorded in the financial statements only where it is more likely than not that the tax position would be sustained on the pure technical merits, assuming the relevant taxing authorities have full knowledge of the facts and circumstances and assuming they will review the position.

More-likely-than-not standard

The benefit from a tax position is recognized in financial statements if the tax position meets the more-likely-than-not standard. Entities must recognize the financial statement impact of a tax position for the first time when it is more likely than not that the position will be sustained on audit.

This determination is made based on a review of the technical merits of the facts, circumstances, and information available at the reporting date and is a matter of judgment based on all available information. Federal guidance says this must include the resolution of any related appeals or litigation processes where applicable. If a company determines that they’ve met the recognition threshold, they positively assert that they believe they’re entitled to the tax benefits from that tax position.

There are a variety of factors to consider in determining whether the more-likely-than-not standard is met. Each income tax position, or unit of account, needs to be assessed in isolation. Specifically, entities may not offset or aggregate with other tax positions.

Example: Defining units of account

Assume Company A does not file a state income tax return in State X on the basis that it is not subject to tax in State X. That is a tax position. Now, assume Company A files a tax return in State Y and that State Y has a throwback income sourcing rule. Under that rule, State Y asserts it can throw back out-of-state receipts for apportionment/sourcing to State Y where such receipts are not subject to tax elsewhere. Assume further that the question of what it means to be subject to tax under State Y’s law is uncertain. While the two issues are somewhat interrelated, they constitute separate units of account and should not be netted or offset against one another.

Similar interrelationships arise in other contexts, such as international corporate taxes, where the potential incremental foreign liability may give rise to incremental foreign tax credits.

Examination of a recognized tax position

Entities should assume the recognized tax position will be examined by the relevant taxing authorities and that they will have full knowledge of all relevant information. This differs from the loss contingency rules in ASC 450-20, under which audit risk historically has been a factor some consider in assessing whether the probable standard is met.

Full knowledge of the facts includes not just the information contained in the tax return work papers, but also information concerning the transaction and/or interpretative position that might influence the outcome. In addition, one’s view of the technical merits is influenced by taxing authority sources, including:

  • Statutes
  • Legislative history and intent
  • Interpretative and legislative regulations
  • Case law
  • Widely known administrative practices in prior dealings with the reporting entity and similar entities
  • Other germane guidance applicable to the facts and circumstances

Verifying that prior fact patterns are consistent with the fact pattern at issue can be challenging. For example, a preparer derives a comfort level on a provision based upon what a colleague or advisor shared about the sustention of a similar matter for another taxpayer. How many layers of the onion one peels back differs from case to case:

  • Were there unique relationship items in the other matter?
  • Were issues traded in the other matter? If not directly, were there other items that indirectly impacted the resolution?
  • Did audit currency have an impact?
  • Did the level of staffing and sophistication on either the taxpayer or government side have a role to play?
  • Is the materiality of the income tax position in relationship to the size of the taxpayer comparable?

Being in the same geographic locale or industry may not be the determinative factor or even a significant factor in determining comparability to assess whether a widely known administrative practice is applicable.

How is a recognized tax position reported on a balance sheet?

After determining that an uncertain tax position meets the recognition standard, meaning it has a more-likely-than-not chance of being sustained by the taxing authority, an entity needs to measure the amount of the benefit to be booked. This happens during the second step: the measurement step. Of course, if the recognition step is not achieved, there is no tax benefit to measure.

Measurement analysis is inherently a management judgment. Specifically, management must determine the greatest amount of tax benefit that is more than 50% likely to be sustained upon examination by the taxing authority, assuming full knowledge of all relevant information. The 50% likelihood determination is based on measuring the cumulative probabilities of potential outcomes for a given tax position.

The cumulative probability approach to measuring tax benefits

When measuring the tax benefit amount likely to be sustained, an entity needs to consider the amounts and probabilities of the outcomes it could realize upon settlement based on the facts, circumstances, and information available at the most recent reporting date.

Start with the potential outcome anticipated to generate the greatest benefit and assign a probability of occurrence to that scenario. If the likelihood is more than 50%, the measurement process is complete, and a benefit is recorded for that outcome scenario.

If the probability point for that greatest benefit is less than 50%, analyze the next greatest benefit that might be achieved and assign a probability of occurrence to that outcome. Then, add this outcome probability to the probability of the first outcome. If the combined probability is greater than 50%, the benefit amount recorded is the amount associated with that second outcome scenario.

Management repeats this process until they identify a potential outcome that has a cumulative probability of at least 50%.

The degree of analysis required to produce a cumulative probability assessment and the accompanying level of documentation may vary from position to position depending on the level of technical and factual complexity. In practice, the documentation behind these will be heavily influenced by management judgment and prior experience. Since measurement is inextricably linked with how management is willing to resolve a matter – as well as how the relevant taxing authority is willing to treat the matter – there is some element of control and certainty to this process, however slight, where management has a conservative view of the degree of benefit it is willing to accept to resolve a matter. For example, management may be averse to protracted matters of controversy and want faster certainty, which may influence it to accept a lower and more conservative amount of ultimate benefit in exchange for expedited certainty.

Navigate the ASC 740 income tax provision with confidence

From recognizing uncertain tax positions to accounting for net operating losses and tax credits, calculating your company’s provision for income taxes under ASC 740 requires a nuanced understanding of a multitude of factors. Download a complimentary copy of our Essential Guide to ASC 740 for key insights to help you navigate the income tax provision process.

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