August 7, 2009
On August 7, 2009, Tax Executives Institute submitted the following comments to the International Ac-counting Standards Board on an Exposure Draft of International Accounting Standard 12 — Accounting for Income Tax. TEI’s comments were prepared under the aegis of its Financial Reporting Committee, whose chair is Terilea J. Wielenga of Allergan, Inc. Eli J. Dicker, TEI Chief Tax Counsel, served as legal staff liaison on this project.
As the preeminent association of in-house tax professionals in the world, Tax Executives Institute is pleased to submit comments to the International Accounting Standards Board (IASB) on its Exposure Draft to revise the existing standard for Income Taxes. Our comments focus on four areas in the Exposure Draft: Investments in subsidiaries (Question 4); Uncertain tax positions (Question 7); Allocations of tax to components of comprehensive income and equity (Question 13); and Disclosures (Question 17).
The IASB undertook this project for two reasons: First, to respond to requests for clarification of various aspects of IAS12, and second, to advance the agreement between the IASB and the U.S. Financial Accounting Standards Board (FASB) to consider the accounting for income tax as part of their work to reduce differences (i.e., converge the standards) between IFRS and U.S. generally accepted accounting principles (GAAP).
TEI applauds the IASB for its efforts to narrow the differences between international and U.S. GAAP standards and to move toward a single set of high-quality accounting standards for financial reporting purposes. Convergence of U.S. GAAP and international accounting standards (e.g., in respect of accounting for income taxes) will facilitate those objectives.
Background
Tax Executives Institute was founded in 1944 to serve the professional needs of in-house tax professionals. Today, the organization has 54 chapters in North America, Europe, and Asia, with the majority of our members working for companies resident in the United States. As a broad-based, global organization, TEI has a significant interest in promoting sound tax and regulatory policy, as well as in the fair and efficient administration of the tax laws.
Our 7,000 members represent 3,200 of the largest companies in the world. They are accountants, lawyers, and other employees who are responsible for the tax and financial reporting, compliance, and planning affairs of their employers in executive, administrative, and managerial capacities. As such, they deal with accounting principles in two ways. First, accounting standards promulgated by the FASB and the IASB undergird the books and records that serve as the starting point for tax compliance in the United States and many other countries. Second, tax executives are responsible (alone or in conjunction with other corporate departments) for implementing the specific rules for accounting for income taxes that form a part of the financial statements and required note disclosures.
Summary of Recommendations
With regard to Question 4, “Investment in Subsidiaries,” TEI urges that the revised standard should establish a rebuttable presumption that all foreign earnings will be repatriated, provided that the presumption of repatriation must be overcome by sufficient substantive evidence demonstrating that the earnings
will be postponed indefinitely. In the area of “Uncertain Tax Positions” (Question 7), TEI recommends that the “probability based recognition threshold” embedded in FIN48 be preserved in the revised IAS12 standard. Regarding “Allocations of Tax to Comprehensive Income,” (Question 13), TEI urges the Board not to adopt a “backwards tracing approach” to tax allocations. And, finally, in the area of Dissclosures,” (Question 17), TEI offers recommendations concerning disclosures relating to intercompany transfers, deferred tax reconciliation and effective tax rates.
Question 4: INVESTMENTS IN SUBSIDIARIES, BRANCHES, ASSOCIATES AND JOINT VENTURES [BC 39-44]
Under U.S. GAAP, parent companies must record deferred taxes for the unremitted earnings of their foreign subsidiaries under the presumption “that all undistributed earnings of a subsidiary will be transferred to the parent entity.” [FASB ASC 740-30-25-3.] That presumption “may be overcome, and no income taxes shall be accrued by the parent entity…if sufficient evidence shows that the subsidiary has invested or will invest the undistributed earnings indefinitely.” [FASB ASC 740-30-25-17.] For example, a U.S. parent company includes tax credits related to the undistributed earnings of its foreign subsidiary at the distributed income tax rate of the subsidiary (i.e., the future tax credits reflected in the deferred taxes of the parent company are measured at the subsidiary’s distributed income tax rate rather than the undistributed rate) unless the company represents that its subsidiary earnings are indefinitely reinvested. [FASB ASC 740-30-25-41; EITF 95-20.]
The IASB’s recommendation that a parent company’s tax assets and liabilities include the effect of expected future distributions based on the subsidiary entity’s past practices and expectations of future distributions is similar to current treatment under U.S. GAAP, but will represent a significant change for those who file using IFRS, under which the recognition of deferred tax is based on whether an entity controls the timing of the reversal of the temporary difference and the probability of it reversing in the foreseeable future. Since the standards in the Exposure Draft and U.S. GAAP are roughly similar, we recommend that the current U.S. GAAP standard [FASB ASC 740-30-25-17; APB23, Par. 12] be adopted in order to simplify convergence by minimizing the number of filers affected by this change.
Under the general rule contained in the Exposure Draft, Appendix B, Paragraph B4, parent companies must recognize the deferred taxes for unremitted subsidiary income, subject to an exception (contained in Paragraph B5) where the investment is essentially permanent in duration and it is apparent that the temporary difference will not reverse in the foreseeable future. The Exposure Draft defines an investment in a foreign subsidiary or foreign joint venture as “essentially permanent in duration” to the extent that the entity has evidence of specific plans for reinvestment of the foreign subsidiary’s or joint venture’s undistributed earnings demonstrating that remittance of the earnings to the parent or investor will be postponed indefinitely (Appendix B, Paragraph B6). This clearly requires the intent of the parent company to reinvest earnings indefinitely and not repatriate earnings. Requiring sufficient evidence to support management’s conclusions on this determination will enable auditors to better review the bases for those determinations.1
Having sufficient evidence in place would also allow issuers to consider when changes in circumstances necessitate a change in the treatment of subsidiary deferred taxes. For example, when it “becomes apparent that all or part of an investment in a foreign subsidiary or joint venture had become essentially permanent in duration, the entity shall derecognize any related deferred tax asset or liability.” (Appendix B Paragraph B7). TEI recommends that the revised standard clarify that the entity would need to provide sufficient evidence documenting the change in facts necessitating this change, thereby substantiating that management’s intent has changed. The revised standard should also rebuttably presume that all foreign earnings will be repatriated, providing that the presumption of repatriation must be overcome by sufficient evidence demonstrating that remittance of the earnings will be postponed indefinitely or supported by other representations from management.
Question 7: UNCERTAIN TAX POSITIONS [BC57 - BC63]
For fiscal periods beginning after December 15, 2006, companies preparing financial statements under U.S. GAAP must apply the provisions of FASB Interpretation No. 48 [FASB ASC 740-10] with respect to their uncertain tax positions (UTP). Complying with FIN48 [FASB ASC 740-10] requires companies to expend considerable resources to review and document their UTP’s, in large part because the approach departed substantially from the approach in Financial Accounting Standard No. 5 (FAS5) for assessing and accounting for tax contingencies. In addition, companies have had to establish policies and procedures to identify, assess, and evaluate each UTP on an ongoing, periodic basis to determine what changes, if any, are required. Undergirding FIN48 [FASB ASC 740-10] is a “probability based recognition threshold.” While straightforward in theory, in practice, FIN48 [FASB ASC 740-10] presented significant interpretative challenges.
Against this background, IASB proposes another new concept for assessing uncertain tax positions, specifically, the “probability weighted average of all possible outcomes.”
TEI has several concerns about this method of assessment. First, U.S. GAAP filers have recently been subjected to a shift in how UTPs are measured. It is only now, after several reporting cycles and the expenditure of considerable time and resources that most companies have adapted to the new requirements and developed consistent and efficient procedures to comply. The introduction of a new methodology will disrupt one of the most complex areas of income tax accounting.
Second, a “probability weighted average” approach to assessing uncertain tax positions would be difficult to interpret and apply consistently. Assigning a probability to each possible position would require filers to speculate about what position a tax authority will take and how the authority will support that position. Because the tax law is by no means black and white, many issues, such as transfer pricing, can yield multiple outcomes. Assigning a probability to each possible outcome and then weighing each outcome using that probability would force issuers to include even the most unlikely outcomes in their calculations, often resulting in UTP reserves being overstated. Furthermore, because the approach does not permit an entity to reserve for an amount representing actual settlement outcomes, it would by definition always be an incorrect estimate.
TEI believes the approach of FIN48 [FASB ASC 740-10] is preferable because it does not require a company to estimate probabilities on positions that have a remote possibility of materializing. Further, the absence of a recognition threshold (as proposed in the Exposure Draft) would result in potential inaccuracies by requiring companies to recognize tax benefits that are highly uncertain or even for those for which no or only meager authority exists. Likewise, reserves would have to be provided for highly certain positions if there are possible outcomes yielding less than 100 percent of the tax benefits. The measurement of tax positions that are at the highly certain or highly uncertain ends of the probability spectrum should not be skewed by outcomes that are remote.
TEI believes that retention of the “probability based recognition threshold” standard embedded in FIN48 [FASB 740-10] will promote consistency in application and also produce more accurate determinations of how issues will ultimately be settled. In addition, FIN48 strikes an appropriate balance between detail and discretion by requiring issuers to provide an aggregated roll forward of their gross uncertain tax position balances rather than detailed descriptions of each position. This data provides financial statement users with meaningful information regarding the organization’s uncertain tax positions without potentially prejudicing the issuer by requiring detailed, item-by-item factual disclosures.2
In contrast, Paragraph 49 of the Exposure Draft would compel potentially prejudicial disclosure obligations by requiring “a description of … [each] uncertainty,” with little concomitant benefit to the user of the financial statement. TEI submits that Paragraph 49 should be deleted from the Exposure Draft and replaced as part of an adoption of FIN48.
Accordingly, TEI recommends that the FIN48 standard be adopted without change.3 Adopting a modified FIN48 will cause unnecessary complexity without resulting in more accurate financial reporting.
If, however, the IASB does not fully embrace FIN48 and proceeds with the “weighted average probability” proposal, TEI recommends that key terms and concepts (from FIN48) have similar definitions or treatment in the final version of the Exposure Draft. Hence, the IASB should provide consistent guidance on
the following concepts:
a. Defining of tax position.
b. Determining the unit of account for tax positions.
c. Explaining how administrative practices and precedents of the taxing authority shall be taken into
account.
d. Explaining how companies should account for and classify interest and penalties.
e. Explaining how companies should classify liabilities for uncertain tax positions.
f. Explaining when a tax position should be considered effectively settled.
In addition, as discussed above, TEI recommends that the disclosure regime of Paragraph 49 of the Exposure Draft be replaced with the more measured requirements of FIN48.
Question 13: ALLOCATION OF TAX TO COMPONENTS OF COMPREHENSIVE INCOME AND EQUITY [BC90-BC97]
The allocation of tax to components of comprehensive income and equity is sometimes referred to as "backward tracing.” Currently, under Financial Accounting Standards No. 109 [FASB ASC 740-10-05-05-1], backward tracing is not allowed and any event that causes a change to a component of tax within comprehensive income or equity is charged to continuing operations. This FAS 109 method, while straightforward, does not provide symmetry between amounts reported as income from continuing operations and the reported tax provision on continuing operations.
IAS12, on the other hand, requires backward tracing to components of tax within comprehensive income or equity and, accordingly, creates an appropriate matching between income from continuing operations and the reported tax provision on continuing operations. It is, however, more complex to both calculate and manage.
TEI recognizes that there are different views on which method is preferable.4 While “backwards tracing” often provides consistency and symmetry between the treatment of an element of comprehensive income and the treatment of any related tax expense, the “continuing operations” approach of FAS109 provides a predictable and certain rule requiring less judgment. Moreover, even if the “continuing operations” approach is less theoretically pure, the tax effects of such transactions are not often meaningful to the reader and result in material discrepancies in tax expense in only very unusual circumstances — items that may be better explained through disclosure.
Because the adoption of a “backwards tracing approach” would require significant change without enhancing the value of the information provided, TEI recommends that it not be adopted.
Question 17: DISCLOSURES [BC104-BC109]
A. Intercompany Transfers
Disclosure of the effect of intercompany transfers of non-monetary assets, required by Paragraph BC 108 raises particular concerns. First, TEI is concerned that the use of the temporary difference approach to intercompany transfers of non-monetary assets could result in earnings management issues. More important, the rule will potentially cause volatility in the effective tax rate. Second, the effect of intercompany transfers of nonmonetary assets would be eliminated at the pretax line, but the tax effect would not. This violates the matching principle, and TEI recommends that this method be reconsidered.5
The method currently used in FAS109 Paragraph 9(e) results in a more meaningful matching of income and expense. The amount of tax actually paid to tax authorities and the tax effect of any resulting temporary difference could be included in a disclosure, which eliminates both the earnings management and volatility issues.
B. Deferred Tax Reconciliation
Paragraph BC109 would require a numerical reconciliation of the opening and closing balances of deferred tax assets for each type of temporary difference and each unused loss and credit. The stated reason for these detailed disclosures is to enable the reader to understand the difference between the total tax expense and the current tax payable.
Since the components of tax expense will be disclosed in the aggregate pursuant to Paragraph 41, TEI questions whether the reconciliation on an item-by-item basis would provide significant additional useful information. Indeed, in most cases the reader can refer to the comparative presentation of the current and prior year deferred tax balances and determine whether deferred tax assets have increased or decreased and draw conclusions regarding the effect on taxes currently payable. For example, if the current tax payable amount is zero but there is a total tax provision, it likely means that a tax loss or credit has been used or that taxable temporary differences (deferred tax liabilities) have increased, either of which should be readily identified in existing disclosures.
Moreover, an average reader of financial statements already has difficulty understanding the myriad disclosures contained in the tax footnote, and the proposed requirements will exacerbate that difficulty. Should the IASB determine that additional disclosures are required to explain the difference between tax expense and tax payable, a concise plain language explanation in a footnote would be more meaningful than a lengthy, detailed reconciliation table.
C. Effective Tax Rate
Paragraph 43 provides that “[t]he applicable tax rate is the rate of tax in the country in which the entity is domiciled; aggregating the tax rate for national taxes with the rates for any local taxes that are computed on a substantially similar level of taxable profit. The average effective tax rate is the tax expense recognized in profit and loss divided by pre-tax profit or loss.”
While including the local or provincial tax rate in the starting point for the effective tax rate reconciliation would potentially provide financial statement users with some useful information regarding the “structural statutory tax rate” in the parent company’s country of domicile, that is not the case with respect to U.S. filers. For them, the effective tax rates and the apportionment and allocation of income among the states are subject to change from year to year as business activity fluctuates from year to year thereby diminishing the comparability of the reported results. The starting point will also differ from company to company, so the comparability of financial statements and disclosures will further be diminished. Accordingly, we do not believe that local taxes should be included in the definition of applicable tax rates (described in Paragraph 43) for the disclosure of the relationship between tax expense and pre-tax profit or loss (commonly referred to as the effective tax rate reconciliation). The inclusion of local taxes would likely result in a different starting point each year for U.S. filers thereby diminishing the comparability of the reported results. Rather, local income taxes including U.S. state income taxes should be an item included in the reconciliation rather than included in the starting point of the reconciliation.
Conclusion
Tax Executives Institute appreciates the opportunity to offer its views on the Exposure Draft. If you have any questions about the Institute’s views, or if we can be of further assistance as the IASB considers these important matters, please do not hesitate to contact Terilea J. Wielenga, Chair, TEI Financial Reporting Committee, at 714.246.4030 or wielenga_teri@allergan.com, or Eli J. Dicker, TEI’s Chief Tax Counsel, at 202.638.5601 or edicker@tei.org.
Sincerely yours,
Vincent Alicandri
International President
Tax Executives Institute, Inc.
1 Currently, U.S. GAAP requires that parent companies maintain evidence of specific plans for reinvestment of undistributed earnings of a subsidiary which demonstrate that remittance of the earnings will be postponed indefinitely.” [FASB ASC 740-35-20-17.]
2 FIN48 does require issuers to provide more detailed disclosures regarding certain uncertain tax positions (i.e., for significant increases or decreases in uncertain tax position balances expected within 12 months). While the actual level of detail required in those instances remains unclear, those disclosures are more discreet than the ones contemplated in Paragraph 49 of the Exposure Draft.
3 Our comment should not be interpreted as an unequivocal endorsement of FIN48. Numerous TEI members would still prefer that the accounting for tax uncertainties be governed under FAS5.
4 For example, the intra-period allocations rules of FAS109, in application, can result in a tax amount being lodged in other comprehensive income (OCI) that does not equal the deferred tax asset or liability on the balance sheet that was established for the pre-tax temporary difference recorded in OCI. This disproportionate effect will remain until the item that gave rise to the tax effect no longer exists or is reclassified to continuing operations, which may be a very distant future event.
5 This methodology was the subject of TEI’s comment letter to Sir David Tweedie, dated 27 July 2004, which included a comprehensive example and recommendation that the accounting methodology for Deferred Tax Accounting for Intercompany Profit in Inventory be conformed to FAS 109. We stand by that recommendation with respect to intercompany transfers of non-monetary assets.