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Comments on IASB Income Tax Accounting

Exposure Draft ED/2009/02


The Exposure Draft dealing with Income Tax was published for public comment on 31 March 2009 by the International Accounting Standard Board (“the Board”).

This document contains comments on question 7 and 16 as set out in the Exposure Draft.


1. The proposed standard retains the basic approach to accounting for income tax, known as the temporary difference approach which objective is to recognise now the future tax consequences of past events and transactions, rather than waiting until tax is payable.

2. The Board considered FIN 48 (Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109) issued by the FASB. FIN 48 requires an entity to recognise tax benefits it has claimed only if it is more likely than not that the tax authorities will accept the claim. If a tax benefit meets the recognition threshold, the amount recognised is the maximum amount that is more likely than not to be accepted by the tax authorities.

3. Applying that reasoning, the Board concluded that an entity has a liability to pay more tax if the tax authority does not accept the amounts submitted.

4. It is therefore proposed that the uncertainty be included in the measurement of tax assets and liabilities. That is done by measuring current and deferred tax assets and liabilities using the probability-weighted average of all possible outcomes theory (herein referred to as the probability theory).

5. The proposed wording of the above amendment in the Draft International Financial Reporting Standard X Income Tax is set out as follows under the heading Measurement” at paragraph 26: outcomes shall be based on new information, not a new interpretation by the entity of previously available information.”

6. There are no examples of applying the probability theory included in the Exposure Draft but the following is clarified:

6.1. In applying the probability theory to measure the tax assets and liabilities it is assumed that tax authorities will examine the amounts reported to them by the entity and have full knowledge of all relevant information (at “Measurement” para 26 of the Exposure Draft).

6.2. No possible outcomes are ignored in the measurement (at BC60 of the Basis for Conclusions).

6.3. The tax assets and liabilities are not discounted amounts (at BC60 of the Basis for Conclusions).

6.4. The Board does not intend entities to seek out additional information for the purposes of applying the measurement. Rather it proposes only that entities do not ignore any known information that would have a material effect on the amounts recognised (at BC63 of the Basis for Conclusions).

6.5. In contrast with FIN 48, the Board believes that the use of the probability theory without a recognition threshold provides more relevant information than an approach that uses a probability based recognition threshold.

7. There is no definition of “material” as used in para BC63 and BC103 of the Exposure Draft Basis for Conclusions, explaining the New Standard on Income Tax. INVITATION TO COMMENT

8. Comment on question 7 – which states as follows: “Question 7 – Uncertain tax positions IAS 12 was silent on how to account for uncertainty over whether the tax authority will accept the amounts reported to it. The exposure draft proposes that current and deferred tax assets and liabilities should be measured at the probability-weighted average of all possible outcomes, assuming that the tax authority examines the amounts reported to it by the entity and has full knowledge of all relevant information. (See paragraphs BC57 – BC63 of the Basis for Conclusions.) Do you agree with the proposals? Why or why not?”

9. To place into context the comparability FIN 48, a short summary is provided:

“FASB Number 109, in the past, contained no guidance on accounting for income tax assets and liabilities, resulting in businesses taking inconsistent positions. According to commentators on FIN 48:

“FIN 48 is an attempt to reconcile the inconsistencies by prescribing a consistent recognition threshold and measurement of tax assets and liabilities. It also gives taxpayers a clearly defined set of criteria to use when recognizing and measuring uncertain tax situations for financial statements, as well as specifying additional disclosures regarding the uncertainty.”

The evaluation of a tax situation for FIN 48 purposes is based on a two-step process:

The first step is recognition: The business determines whether it is more likely than not (which is a 50% or greater likelihood) that a tax situation would be upheld on examination, including resolution of any ensuing litigation process, based on the technical merits of the tax situation;

The second step is measurement: The tax situation that meets the more likely than not recognition threshold is measured to determine the amount of benefit to recognize on financial statements.

In asserting the more likely than not standard, all the facts and circumstances are taken into account. Additionally, the taxpayer must presume that the tax situation will be examined by the Revenue Service with full knowledge of all the facts, technical merits of the relevant tax law and their applicability to the facts and circumstances of the tax situation. The taxpayer may take into account any past administrative practices and precedents of the Revenue Service in its dealings with the business, when those practices and precedents are widely understood. Finally, each tax situation must be evaluated without consideration of the possibility of offset or addition to other tax issues. The appropriate timing of claiming the benefits of a tax issue is when it becomes clear that the tax issue has a more likely than not chance of being upheld. If a previous tax issue does not meet the more likely than not standard, then it shall be adjusted in the first period after the effective date of FIN 48 (1 January 2007).

A business must classify the liability associated with an unrecognized tax issue as a current Liability to the extent the business anticipates payment of cash within one year or the operating cycle, if longer. The liability for an unrecognized tax issue shall not be combined with deferred tax liabilities or assets. In addition to taking into account the benefit that a particular tax issue will create for a particular business, interest and penalties must also be computed in addition to the tax liability, where required by the relevant tax legislation. A tax liability will cease to be a
liability during the first interim period in which any one of the following three requirements exist:

– the more likely than not recognition threshold is met by the reporting date;

– the tax issue is settled through negotiation or litigation;

– the statue of limitations for the Revenue Service (prescription) to examine a tax issue has expired, unless there has been fraud, misrepresentation or non-disclosure by the taxpayer.”

10. The writer does not agree with the Exposure Draft proposal for the reasons set out below.

11. The Disclosure is too onerous.

11.1. The Exposure Draft seems to suggest that all amounts affecting current and deferred tax assets and liabilities must be considered and taken into account irrespective of the amount concerned and irrespective of the likelihood of a dispute.

11.2. There is no recognition threshold applicable to the disclosure.

11.3. In addition, all possible outcomes should be included in the analysis of the amount.

11.4. A simple example illustrating the amount of work involved for one item affecting the tax liability is as follows: Assume a deduction giving rise to a tax benefit of R1 million is claimed. A probability should be attached to all possible outcomes assuming the tax authority examines the amounts reported and has full knowledge of all relevant information. No possible outcomes should be ignored in the measurement.

Possible Outcomes Probability Risk in R
Tax benefit claimed is not challenged by the tax authority 50,00% 0
Tax benefit claimed is challenged by the tax authority and the taxpayer wins the matter 20,00% 0
Tax benefit claimed is challenged by the tax authority and the tax authority wins the matter 20,00% 200 000
Tax benefit claimed is challenged by the tax authority and the matter is settled 50/50 5,00% 25 000
Tax benefit claimed is challenged by the tax authority and the matter is settled 70/30 in favour of the tax authority 5,00% 35 000
100,00% 260 000

11.5. This could be a onerous task for the following reasons:

11.5.1. There is no threshold as in the application of FIN 48. The number of items in respect of which the analysis should be done is numerous. With no threshold, it means every single item having a tax effect should be considered. This goes against the principle of materiality employed during an audit process.

11.5.2. The number of possibilities to include in the analysis is endless.

11.5.3. The liability is contingent and it should be recognised even where the possibility of realizing is remote. This goes against general accepted accounting practice.

11.5.4. A tax dispute takes time to run its course and this impact on the accuracy of the disclosed contingent liability. It could take up to two years after submitting a tax return that an item is queried and another year before an assessment is eventually issued. It could be settled in ADR after six months or if taken all the way to the Court of Appeal, it may take up to five years. During this time, the time value of money (which according to the Exposure Draft should be ignored) could play a significant role on the amount of the liability.

11.5.5. The effect that prescription may have is difficult to take into account. Nothing is said about applying the statue of limitations which is expressly provided for in FIN 48.

12. Tax Authorities will take Advantage of the Disclosure.

12.1. After implementing FIN 48 in the USA, the increase in tax accrual working papers was a major concern for USA taxpayers because it created a responsibility for taxpayers to look at tax risks and at the same time an opportunity for the tax authority to exploit the situation.

12.2. Although the eventual outcome of the US v. Textron CA No., 06-198T (“Textron”) judgment, a US case concerning the disclosure of working papers during an audit, was in favour of the taxpayer (but recently overturned on appeal in favour of the IRS) and the IRS agreed to exercise restraint in line with the judgment, the judgment is not binding on tax authorities world-wide. There is no guarantee that tax authorities worldwide will exercise a similar restraint.

12.3. The degree of disclosure in terms of the Exposure Draft is not clear, ie detailed workings as opposed to a consolidated number. The South African Revenue Service (“SARS”) is already querying details of tax provisions raised by companies. SARS audits will now focus their investigations on annual financial statement (“AFS”) tax disclosures. This will create far greater exposures, even in remote situations, which otherwise may never have materialized into a dispute or controversy.

12.4. In addition, tax liability numbers on the AFS of high risk taxpayers will significantly increase after implementation of the standard. This will trigger tax audits for these taxpayers, without any “friendly” disclosure or settlement process available to taxpayers, as is the case in the USA with FIN 48. There are developed tax uncertainty processes given by the IRS setting out the settlement procedures. None is guaranteed to taxpayers in other jurisdictions.

13. The meaning of “material”.

13.1. What is “material” for accounting purposes as contemplated in para BC63 and BC103 of the Exposure Draft. “Material” is not defined. IASB have made certain findings on “relevance”. Is relevance material? If it is, the IASB state: “To be relevant, information must be capable of making a difference in the economic decisions of users by helping them evaluate the effect of the past and the present events on future net cash flows-or confirm or correct previous evaluations-Also, the information must be available when the users need it-“.

13.2. This means that any tax uncertainty after it has been through the compulsory internal tax review process (in that the information is available, and will influence future cash flows based on a probability analysis) could be material, as it satisfies all these criteria.

14. Attorney/Client Privilege.

14.1. In many respects this disclosure requirement undermines the attorney/client privilege taxpayers are entitled to.

14.2. This issue was also considered in the Textron case. It still remains to be decided whether Textron waived confidentiality when it gave its internal documents to the auditors.

14.3. In the implementation of the Exposure Draft, it can be anticipated that SARS will argue that the internal documents given to the auditor will form part of their working papers and will not be subject to attorney/client privilege. This will lead taxpayers to have to implement measures where any tax risk review documentation is not exposed to auditors, but kept in their possession of their qualified attorney in anticipation that this information may realistically be the subject of tax litigation with SARS, because it is anticipated that

SARS will actively pursue any disclosures for the reasons stated above, leading to potential litigation.

15. Constitutional issues.

15.1. Section 33 of the South African Constitution states that no person can be compelled to give self incriminating evidence. Self incrimination includes being exposed to punitive penalties.

15.2. The Companies Act at section 285A read with 440FF, states that widely held companies must comply with generally excepted accounting standards in the preparation of their financial statements. This means that if the relevant taxpayers do not comply with the standard, the Companies Act imposes an administrative penalty, and if the transgression is not remedied, a criminal penalty on the offending party. It is therefore compulsory for widely held companies to comply with the Exposure Draft.

15.3. SARS will be able to access this information in one of two ways:

15.3.1. By approaching a third party auditor to present its working papers, in which case SARS is at liberty to pursue any administrative or criminal actions against the taxpayer; or

15.3.2. By approaching the taxpayer direct, and invoking the compulsory information machinery of the Income Tax Act, where the taxpayer may be able to rely on a “self incrimination” defence, that entitles the taxpayer to any punitive penalty immunity, because the taxpayer was compelled to give the evidence to SARS.

15.4. The dicotomy of these two scenarios exposes the unfairness and uncertainty that will arise in the future.

15.5. The “hardliner” defence in terms of the Income Tax Act will be that the party refusing to give the information to SARS, can “show good cause” why they refuse SARS” request, because:

15.5.1. the opinions expressed in working papers are not information in the narrow sense, pertaining to a specific transaction at the time of its execution – but opinion or conjecture, a view formed, after the fact; or

15.5.2. the taxpayer would be able to raise the “self-incrimination” reason as “good cause”. However, both are unlikely to be followed as a defence by most. SUGGESTED ALTERNATIVE APPROACH

16. The following alternative approach is suggested:

16.1. A threshold for recognising the liability should apply in line with FIN 48. This will make the disclosure less onerous.

16.2. Disclosure in the AFS should be minimal to avoid exploitation by the tax authorities.

16.3. Procedures should be implemented where the tax accrual working papers for tax uncertainties are regarded as subject to attorney/client privileged. This will be difficult to impose on the legislatures of various governments.


17. The Board decided to follow FIN 48 in that the classification of interest and penalties payable to tax authorities is a matter of accounting policy choice that should be disclosed.

18. Disclosure of the amount of interest and penalties is not required unless the amount is material in terms of paragraph 97 of IAS 1. Invitation to Comment

19. Comment on question 16 – which states as follows: “IAS 12 is silent on the classification of interest and penalties. The exposure draft proposes that the classification of interest and penalties should be a matter of accounting policy choice to be applied consistently and that the policy chosen should be disclosed. (See paragraph BC103 of the Basis of Conclusions.) Do you agree with the proposals? Why or why not? Suggested Alternative Approach

20. History in the USA shows that with FIN 48, about 42% of companies surveyed understated the interest and penalties component. The precise basis as to how this must apply, with reference to the probability theory, must be carefully spelt out to ensure proper compliance.

21. What is stated with reference to Question 7 is repeated here, as well, and in particular in relation to what is “material” enough to be disclosed.

Previously published by the Thomas Jefferson School of Law, February 2009

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