With Sarbanes-Oxley tamed and states hungry for new revenue, tax professionals say 2008 will be a year of reckoning for corporate finance staffs booking tax benefits and liabilities in accordance with Financial Interpretation No. 48, Accounting for Uncertainty in Income Tax.
FIN 48 is the requirement that preparers disclose in financial statements where they may have holes in their corporate tax strategies, such as a tax bill the company might still have to pay if a particular tax position doesn’t hold up under audit or legal challenge.
While preparers and auditors have been strapped to Sarbanes-Oxley compliance concerns, “auditors have been very reasonable” on FIN 48 assertions, says Jacqueline O’Neil, managing director at Huron Consulting Group. “Companies and practitioners were so beaten up over Sarbanes-Oxley, we expected the same thing from FIN 48, but it just hasn’t been as painful for most companies as they anticipated.”
That may now change. State governments are looking for new sources of revenue, and a favorite target is corporate income by out-of-state entities, says Michael Semes, a state and local tax partner for the law firm Blank Rome.
In the tax world, it’s called “economic nexus.” That’s where a state says a portion of a company’s income is taxable if the company does business inside the state—regardless of whether the business has any physical presence there. Case law increasingly sides with states that claim nexus, and it’s a favored tax source for state governments because it’s not a new tax or a tax increase on state residents.
From O’Neil’s perspective, auditors have been light on the FIN 48 analyses so far, especially where companies may have never declared income in particular states that have potential nexus claims. In today’s revenue-hungry environment, however, “I think FIN 48 is going to be a huge focus in 2008,” she says.
Semes cites recent cases in Alabama and Louisiana that build on a nexus claim made earlier in South Carolina, which said that income related to the use of a logo or trademark within the state is taxable. Along the same lines, a New Jersey Supreme Court decision said even when a company’s sole contact in New Jersey is licensing of trademarks to affiliates who use them in the state, the related income is subject to the state’s corporate business tax.
The concept builds on the notion that an economic presence inside a state is adequate to charge a company an income tax. Semes says he believes the nexus decisions are “constitutionally suspect” even though the U.S. Supreme Court has yet to hear any case on the topic. “The third-party licensor doesn’t even know who the third-party licensee is. You can’t track that,” Semes says.
Tax experts say companies largely do not file state tax returns offering to pay income on such economic presence, partly because the idea is so new and partly because there’s so much uncertainty about what might be considered taxable.
“The concern is that a lot of state tax rules were written when business was different than it is today,” says Rick Rodenbeck, a director with CBIZ Accounting, Tax & Advisory Services. “We have a lot more service business today and a lot more people delivering value electronically.”
But FIN 48—which requires companies to disclose where they may have uncertainty—has companies reconsidering the issue, says Michael DeSimone, international tax manager with Thomson Tax & Accounting. Auditing firms “are saying you need to put up a FIN 48 disclosure on this,” he says.
Precisely what that disclosure should say and how long it should be considered an “open” uncertainty is anyone’s guess. Emily Parker, a partner with Thompson & Knight and former deputy chief counsel for the Internal Revenue Service, says a company might have to carry a prospective liability year after year.
If a company has nexus but does not file a tax return with that state, she notes, the statute of limitations on the tax liability to that state never runs out. “So theoretically, the potential tax liability to that state exists forever,” she says.
As a result, when the company performs its FIN 48 analysis on a given state potentially claiming economic nexus, “the company may have to accrue a liability to that state, and that liability would never go away,” she says. “Even if the company concludes that more likely than not on the merits it does not have nexus, it might still have to accrue a liability to account for some risk.”
Indeed, the company would not only carry the liability, but the liability would grow over time as prospective penalties and interest pile up.
Rodenbeck and Semes say they’ve worked with clients who have asked to approach state tax officials with anonymous proposals to pay some back tax to settle any potential nexus claims, remove the uncertainty, and avoid an endless FIN 48 liability.
“We would go to a state and say, ‘We have a client and here’s the issue. We’d like to propose … they would pay the tax for the last three years, plus interest,’” Rodenbeck says. “We’d try to get the state to waive any review of prior years. Some accept, and some say, ‘No, we want six years plus interest.’”
Rodenbeck gives the example of a company that might determine its prospective tax to a given state at $10,000—which, for many businesses, isn’t a life-threatening sum. Given the costs of any accrued interest and penalties, plus the professional and administrative costs to settle such a tax bill, “it might amount to a couple hundred thousand dollars for a FIN 48 liability,” he says. “If you can work with the state to get it cleaned up for $100,000, it’s beneficial to the client to get it resolved.”
Semes has also represented clients who have offered voluntary disclosures and tax payments to avoid an endless FIN 48 liability. Some states are happy to settle up, he says, while others “get greedy.”
There are more wrinkles, Semes warns. Auditors, living under far more scrutiny since Sarbanes-Oxley was passed, walk a fine line in demanding more FIN 48 disclosure.
“If there have been no changes in the law—and in many instances there haven’t been—if the auditor wasn’t saying in the past that these were uncertain … why all of a sudden isn’t the auditor at fault for not having raised the issues earlier?” Semes asks. “Is there some negligence?”
In addition to the nexus problem, states are also more aggressive on transactions between the parent company and its subsidiaries within a given business, O’Neil says. Wisconsin in particular, she says, objects when an out-of-state company apportions expenses to a Wisconsin-based subsidiary in a way that reduces the subsidiary’s taxable income.
O’Neil says one common practice is for a parent company to apportion to subsidiaries certain shared costs, such as intellectual property, interest expenses, or back-office functions. “Wisconsin says you can’t reduce income in our state by apportioning it to other companies,” she says. “That’s an arm’s-length transaction” and further complicates the FIN 48 disclosure, she says.
Tax experts do agree on one point: Companies wrestling with such issues have no easy solutions. “We’re advising our clients—and I know this is self serving—to hire a lawyer,” quips Semes.