Fin 48—Spawn of Sarbox?
from
May/June 2007
by Craig Mellow
The new accounting regulation known as FIN 48 may be the biggest pain for corporate directors since Sarbanes-Oxley, its regulatory forebear—or, to the idealistic among us, it may be the biggest opportunity yet to plumb the bowels of corporate finance and increase transparency for shareholders. What’s certain is that it takes effect this year, despite pleas by hundreds of companies for a delay.
FASB Interpretation No. 48 (its full moniker) is a brainchild of the Financial Accounting Standards Board, which defines the requirements of generally accepted accounting principles and endeavors to illuminate the myriad tax-reduction ploys that a company’s accountants have historically shared only with God and the Internal Revenue Service. In the past these write-offs, along with any reserves stockpiled against the possibility that the taxman might disallow them, never showed up as such in public financial documents but were lumped in with other miscellanea in a “contingent liabilities” category on the balance sheet. FIN 48 decrees that those potential tax liabilities be reevaluated by a more stringent standard, and that any reserves set by to cover them be published in a footnote. This all starts with year-end 2007 financial statements.
The liabilities in question can be substantial. GlaxoSmithKline, a global drug maker based near London, set a new record last fall when it paid the U.S. taxman $3.4 billion that it was deemed to owe for American operations between 1989 and 2005. Yet even some investors wonder whether the FASB’s cure is not worse than the disease. “I suppose there’s always a benefit to transparency,” says Robert Willens, who analyzes tax and accounting policy at Lehman Brothers, “but the other aspects of [FIN 48] far outweigh the benefits.” For example, the new rule requires corporations to inventory all their tax write-offs worldwide and estimate in percentages the likelihood that each one would be thrown out in case of an audit by the relevant revenuer. If that likelihood is more than 50%, the planned write-off should be abandoned and the taxes paid. If it’s less, the company must set aside as a reserve the relevant percentage of the tax avoided—20% if the risk is 20%, for instance—and declare that sum in its financials.
Until now, few boards have paid much attention to such accounting arcana. That is about to change. “For audit committee members, this is a great opportunity to get to know your company’s head tax guy a lot better than you did in the past,” quips Ken Daly, who heads the Audit Committee Institute at the accounting firm KPMG.
You might also become far more familiar with Excedrin. For one thing, across large swaths of the financial landscape a particular tax authority’s interpretation of a given transaction is simply unpredictable. “There are situations where the law is clear and your position isn’t, but there are also situations where the law itself is not clear,” observes Stuart Seigel, a former chief counsel at the IRS who is now a tax consultant in New York City.
One of these great gray areas is the proper tax treatment of mergers, acquisitions, and spin-offs. Another is the trading activity of financial firms. The issue that skewered Glaxo was socalled transfer pricing, the charges one corporate subsidiary forwards to another not only for goods but also for intangibles like licensing fees and copyrights. The IRS found that the drug maker had artificially decreased U.S. profits by overpayments to the global organization for popular drugs like the ulcer remedy Zantac. The more diverse and multinational a company’s structure, the more headaches it can expect from FIN 48, says Ken Daly.
Traditionally, corporate tax departments interpreted ambiguities as favorably as they dared and dealt with the government if and when it started asking questions. The FIN 48 percentage rule effectively obliges companies to provide the state with a road map showing where it might be able to squeeze extra taxes. “It gives the IRS such an advantage that it changes the dynamics of the auditing process,” Lehman’s Robert Willens says. “These vulnerability estimates will become self-fulfilling prophecies.”
Few board members have the expertise to oversee FIN 48 compliance, especially in the initial phase of inventorying tax positions that have accumulated in the past. One coping mechanism might be for boards to hire specialist consultants to exhume a company’s financial skeletons and help determine the risk of a huge tax bite in the future. Those extra eyes will not come cheap, but as Willens says, “boards can’t afford to rely on the company’s own auditors in this day and age.”
And take heart. Coping with FIN 48 will prove good practice for more tax-related disclosure requirements that Stuart Seigel predicts lie ahead. The tax bill that already shows in financial statements frequently contains a hodgepodge of current payments, taxes owed for previous years, and reserves against the future. “Any sophisticated Wall Street analyst will tell you there is really no way to tell what an effective tax rate is,” says Seigel. “That won’t be addressed overnight, but there is a trend toward more disclosure generally.”
Something to look forward to.
