2008 Tax Conference

2008 OFII Tax Conference 2 La Quinta, CA

Michael Burak – PricewaterhouseCoopers John Hildy – Mayer Brown Rowe & Maw

The views expressed in this presentation are not intended as, and should not be relied on, as accounting, auditing, regulatory or tax advice. The outcome of any independent situation depends on the specific facts and circumstances in which the issue arises and on the interpretation of FAS 109 and other relevant literature, laws and regulations in effect at the time.

IRS Access to Tax Accrual Workpapers


US Audit Environment

• FASB FIN 48 (2006)– Provides structure for analyzing uncertain tax positions and, for

many filers, increases the level of detail behind tax reserve analyses

• PCAOB AS3 (2004)– Audit documentation must be sufficient to allow an experienced

auditor, with no prior connection to the audit, to understand conclusions reached

• AICPA AU 9326 (revised 2003)– Tax accrual and support are responsibility of client– Where support is based upon an opinion of outside advisor,

auditor generally needs access to the opinion, notwithstanding privilege claims


IRS Environment

• Pressures surrounding– Audit currency– Resources– Tax gap

• The IRS has authority to examine any books, records, or papers that may be “relevant” – Arthur Young (1984): US Supreme Court held that tax accrual

workpapers (“TAW”) were “highly relevant” to an IRS audit• Tax accrual workpapers (“TAW”) can be an irresistible treasure

trove– TAW “Cadre” established within LMSB– 6 hours of mandatory FAS 109 training


Fluid IRS “TAW” Policy• IRS historically has followed a self-imposed “policy of restraint” to

resist making blanket request for tax accrual workpapers• In 2004, the policy of restraint began to weaken

– For “listed” transactions• If taxpayer claims benefits from one disclosed “listed”

transaction, requests for TAW for that transaction are mandatory

• If taxpayer claims benefits from one undisclosed “listed” transaction, requests for all TAW are mandatory

• If taxpayer claims benefits from two or more disclosed “listed” transactions, all TAW may be requested as a discretionary matter

– Other transactions: requested in unusual circumstances


IRS Definition of “TAW”

• IRS’s definition of “TAW” is broad:

“those audit workpapers, whether prepared by the taxpayer, the taxpayer’s accountant, or the independent auditor, that relate to the tax reserve for current, deferred and potential or contingent tax liabilities, however classified or reported on audited financial statements, and to footnotes disclosing those tax reserves on audited financial statements. These workpapers reflect an estimate of a company’s contingency analysis, tax cushion analysis, or tax contingency reserve analysis.” IRM 4.10.20.2(2)

• Initially, IRS Chief Counsel advised this did not include ETR reconciliation workpapers, but that advice was withdrawn


Potential Defenses to Discovery

• Attorney-Client Privilege• Section 7525 Tax Advisor Privilege• Work Product Privilege


Attorney-Client and 7525 Privileges

• Applies to communications between attorney/tax advisor and client intended to be confidential– Communications must be for the purpose of providing legal advice– Even 7525 must involve “lawyer’s work,” since there is no parallel

federal accountant privilege (Supreme Court in Arthur Young)– Protects communications, but it does not protect facts

• Waiver– Waived on disclosure to any third party, including financial auditors– Waiver to one party generally waives the privilege with respect to all

parties – Waivers typically extend to all communications on same subject

matter– Even describing the “gist” of communication is a waiver (e.g. “our

counsel gave us a favorable opinion on this issue”)


Work Product Privilege• Protects materials prepared “in anticipation of litigation or for trial”• Courts interpret the “in anticipation” test differently

– First, Second Circuits: protects materials created “because of the prospect of litigation”

– Fifth Circuit: protects documents where “primary motivating force was to assist in possible future litigation”

– Some Circuits: articulation of the standard is somewhat ambiguous• Waiver

– Waived where disclosure is made to an adversary, or where the disclosure makes it more likely that an adversary will obtain document

• Cases discussing financial auditors are split:– Textron, American Steamship, Jaffe, Merrill Lynch find no

waiver– Medinol, Diasonics find waiver

– Waivers generally extend only to the items produced, not other materials


Case Study: Textron

• Textron was embroiled in a contentious IRS audit– 7 of 8 past audits had gone to Appeals; 3 disputes resulted in

litigation– Subsidiary had done 9 listed transactions (SILOs)

• IRS issued a summons for TAW of Textron’s consolidated group– “Master” reserve schedules, plus supporting schedules, notes

and memos– According to Textron, these TAW were prepared by in-house

Tax Department counsel and reflected their advice and legal conclusions on the prospects of prevailing

– Textron had shown these TAW to its outside auditor (E&Y), but had not allowed E&Y to keep copies

– E&Y had agreed to keep the information confidential• When Textron refused to comply with the summons, IRS brought

suit in federal district court in Rhode Island


District Court’s Holding• Last August, the district court held that the workpapers were

covered by ACP/7525, but these protections had been waived upon disclosure to E&Y

• But the court held the documents were protected as work product– Applied controlling First Circuit test: whether the document was

acquired “because of” the prospect of litigation.” • Ask: would the document have been prepared in

substantially the same form irrespective of the anticipated litigation?

– District court held documents were prepared “in anticipation of litigation”, applying a “but for” approach:

“If Textron had not anticipated a dispute with the IRS, there would have been no reason for it to establish any reserve or to prepare the workpapers used to calculate the reserve.”

– So the holding is that, by definition, all of the tax reserve workpapers for all issues must be “in anticipation”


District Court’s Holding (cont.)

• Moreover, court held disclosure to E&Y did not give rise to waiver of work product privilege– E&Y itself was not an “adversary,” despite its public watch dog

role– Nor did the disclosure to E&Y increase likelihood that a true

adversary would subsequently obtain the documents• E&Y had given assurances of confidentiality• E&Y was under professional obligations to keep confidential


Practical Implications

• The district court’s opinion is a great victory for taxpayers• But be cautious…


Practical Implications (cont.)

• It is, after all, a district court opinion • IRS has appealed to Court of Appeals for the First Circuit• Current status of appeal:

– Government opening brief (January 2008)– Textron opening brief (March 2008)– Amicus briefs supporting Textron (April 2008)– Government reply brief (due May 5)



• Attorney-Client and 7525 arguments are very difficult once disclosure to auditor is made– Textron has not even pursued these arguments in its brief– This is true even if auditor does not keep copies



• The work product holding was based on the First Circuit’s friendly “because of” test

• In a Circuit that follows the less-friendly “primary purpose” test, Textron likely loses– The primary reason to create TAW is to compute and support

tax reserve, not to assist in litigation


Practical Implications (cont.)• This is the first opinion to extend work product protection to any TAW,

much less to all of them as a blanket matter

– Government’s brief:

• There is no work product protection for documents that are prepared in the ordinary course of business or that would have been prepared in the same form irrespective of litigation

– Textron’s brief:

• The workpapers were prepared “because of” the potential dispute with the IRS

• If there had been no anticipation of litigation, there would be no reserve

• The fact that TAW were also used for some secondary business purpose (financial statement audit) does not forfeit protection



• The district court’s holding that Textron anticipated litigation rests on factual determinations– Is it credible to anticipate litigation on each and every item in

your reserve schedule?• Is it true that, just because a taxpayer identifies a tax issue

and reserves accordingly, it “anticipates litigation”?– More traditional facts supporting Textron’s claim:

• 7 of 8 cycles went to Appeals• 3 went to litigation• 9 listed transactions• 500 IDRs

– Are there other consequences of anticipating litigation?



• The district court’s holding that there was no waiver rests on factual and legal determinations– Facts:

• E&Y had agreed to keep materials confidential• E&Y was bound by professional obligations of confidentiality

– Legal:• Federal district courts are divided on the issue of whether

auditor is an “adversary”• No appellate court has faced this issue



• The decision does not protect information prepared by outside auditors

– Government’s brief points out that its summons also sought workpapers in possession of E&Y

• Government wants to make this argument because in Arthur Young, the Supreme Court held tax accrual workpapers created by audit firm were not protected as work product

– Textron’s brief:

• E&Y workpapers (if any) are irrelevant; we do not control them

• IRS really wants the ones prepared by Textron’s attorneys, which E&Y does not possess

• Too late to make that argument


Questions

Income Tax Accounting Update: The Emergence

of IFRS


IFRS Overview – A Global Revolution

Countries converging to IFRS with the goal of adoption

Countries that require or permit IFRS

Countries with no current plan to adopt

Source: Economist Intelligence Unit

More than 100 countries require, permit or are converging to IFRS

Top 10 Global Capital Markets

Country Standard ($ in trillions)

US US GAAP 17.0

Japan Converging to IFRS

4.7

UK IFRS 3.1

France IFRS 1.7

Canada Converging to IFRS

1.5

Germany IFRS 1.2

Hong Kong IFRS 1.0

Spain IFRS 1.0

Switzerland IFRS or US 0.9

Australia IFRS 0.8


Reasonable timeline for the US transition to IFRS

2008 2010

2009

2012 2014

2007 2011 2013 2015

March 2007 SEC roundtable on US GAAP reconciliation for IFRS filers

July 2007 SEC proposal eliminating US GAAP reconciliation for IFRS filers

August 2007 SEC concept release on use of IFRS for US companies

November 2007Reconciliation eliminated

Between January 2009 and 2010Potential voluntary application of IFRS permitted for US companies

Between January 2013 and 2015Potential mandatory application of IFRS by US companies


Convergence


Income Taxes Key Differences and Short Term Convergence

IFRS US GAAP

Tax base Dependent on expected manner of recovery or settlement of asset or liability- Use, sale, use and sale.

No definition of tax base

Tentative Convergence outcome:

The Board’s decided on a common definition of a tax base IASB to eliminate requirement that management intent on recovery can affect tax base

IASB decided to clearly establish that the tax base of an asset is determined by the amount deductible by the entity if it sold or otherwise disposed on the asset for its carrying amount at the balance sheet date.



IFRS US GAAPInitial Recognition Exemption

Prohibits recognition of a deferred tax asset/liability for temporary differences that arise from the initial recognition of asset /liability in a transaction that:

–Is not a business combination–At the time of the transaction affects neither accounting nor taxable profit.

IAS 12 states explicitly that an entity does not subsequently recognize changes in this unrecognized deferred tax asset or liability.

Does not provide this exception.

Tentative convergence outcome:

The IASB eliminated this exception.The IASB eliminated this exception.

Fair value of such assets and liabilities should be measured on initial recognition using the same assumptions about the tax base that would be made by other market participants



IFRS US GAAPAcquisition of assets with a tax basis not equal to book basis

IAS 12 currently prohibits the recognition of deferred tax on initial recognition of an asset in a transaction that is not a business combination and does not affect accounting or taxable profit.

No initial recognition exemption;

Uses EITF 98-11


The IASB decided to eliminate the initial recognition exception.

The FASB decided to eliminate EITF 98-11The Boards decided to move to a FV purchase discount model. It was concluded that the deferred tax asset or liability should be recognised as the difference between the fair value of the asset and its tax base multiplied by the tax rate. Any difference between the consideration paid and the sum of the fair value of the asset and the recognised deferred tax amount is recognised as a purchase discount allowance on the deferred tax.



IFRS US GAAPTax rate Enacted or substantively

enactedEnacted


For operations within US taxing jurisdictions: to retain the current approach in FAS 109.

For operations beyond US taxing jurisdictions: to require an approach that is consistent with IFRS.



IFRS US GAAPInvestments in subsidiaries, treatment of undistributed profit

Deferred tax liability is recognised except when the parent is able to control and it is probable that the temporary difference will not reverse

Deferred tax liability is required on temporary differences arising after 1992 that relate to investments in domestic subsidiaries, unless such amounts can be recovered tax-free and the entity expects to use that method. No deferred taxes are recognised on undistributed profits of foreign subsidiaries that meet the indefinite reversal criterion.


The IASB tentatively decided to adopt the current FAS109 approach including the APB23 exception.



IFRS US GAAPIntercompany Transfers of Assets

Contains no exception

Intercompany transfer of assets between jurisdictions is a taxable event and establishes a new tax base for those assets.

Taxes must be paid by the seller on intercompany profits.

Prohibits the establishment of a deferred tax asset for basis differences.


FASB will amend FAS109 to eliminate this exception.



IFRS US GAAP

Foreign Non-monetary Assets and Liabilities

IAS 12 contains no exception.

Prohibits recognition of a deferred tax asset or liability for differences related to assets and liabilities that, are remeasured from the local currency into the functional currency using historical exchange rates and that result from (i) changes in exchange rates or (ii) indexing for tax purposes.


The FASB decided to amend SFAS 109 Para 9f to eliminate this exception



IFRS US GAAP

Distributed or undistributed rate

In measuring deferred tax assets and liabilities, IAS 12 requires use of the tax rate applicable to undistributed profits.

US GAAP requires the use of the tax rate applicable to distributed profits if the tax rate applicable to distributed profits is higher than the tax rate applicable to undistributed profits.


The IASB decided that in jurisdictions that have a different tax rate depending on whether taxable earnings are distributed to owners, an entity should use the rate(s) that it expects will apply to the item being measured, incorporating the entity’s past practices and future expectations of distributions. When determining future expectations of distributions, the entity must have the intention and ability to make distributions for the foreseeable future.

The FASB is still to consider this proposal.



IFRS US GAAPUncertain Tax Positions - Guidance

•IAS 12 is silent on the issue of uncertainty in the amounts underlying current and deferred tax.

•Recognize tax benefit when it is more likely than not to be sustained, measured as the largest amount of benefit that is greater than 50% likely of being realized.

Uncertain Tax Positions - Recognition

•Unit of account is individual tax position, OR •The aggregate positions with a taxing authority for a taxable entity.

•Unit of account is the individual tax position.

Uncertain Tax Positions - Measurement

•Probability weighted average approach, OR•Single best estimate/most likely outcome

•Cumulative probability methodology

Tentative convergence outcome: To be announced



IFRS US GAAPBalance Sheet Disclosure General guidance presented in IAS 12.5

focused upon income taxes including all foreign and domestic taxes based on taxable profits.

FIN 48 liability must be presented separately from other income tax liabilities.

Classification on Financial Statements

Must be presented as a component of current tax liability unless entity has an unconditional right to defer payment for more than 12 months.

Liabilities are classified as non-current unless a cash payment is expected within the next 12 months.

Classification of Interest and Penalties

When interest and penalties can be identified and separated from related tax liability, they must not be classified as tax expense in the income statement. They must be classified as finance costs or other operating expenses.

Accounting policy election that permits “above” or “below” the line treatment.

Disclosure of Reserves Not applicable Substantial interim and annual qualitative and quantitative requirements.

Tentative convergence outcome: To be announced



IFRS US GAAP

Subsequent changes in deferred taxes related to items initially recorded directly in equity

Subsequent changes are recognized directly in equity. (i.e. full backward tracing with limited exclusions)

Subsequent changes are recognized in income, with limited exceptions.


The IASB decided to amend IAS 12 to adopt the intraperiod allocation requirements of SFAS 109. Subsequent changes in deferred taxes related to items initially recorded directly in equity may under the intraperiod allocation rules be recognized in other Income Statement categories e.g. continuing operations, discontinued operations or equity.

Current areas of divergence in the area of income taxes



IFRS US GAAPDifference between book basis goodwill and deductible tax basis goodwill

IFRS does not allow for a DTL to be recorded on a day one difference between book basis goodwill and deductible tax goodwill. A DTA may however be recognized where tax exceeds book.

No deferred taxes are recognized for an excess of tax basis goodwill over book basis goodwill.


As part of the business combinations convergence project, it has been agreed that where there is tax goodwill in excess of book goodwill on acquisition, deferred taxes will be provided on the excess tax depreciation using a simultaneous equation methodology i.e. record the deferred tax asset.



IFRS US GAAPBusiness Combinations Measurement of non-controlling

interests using fair value or the proportionate share of the acquiree’s identifiable assets

Measurement of non-controlling interests using fair value

Tentative convergence outcome:•Changes inside the measurement period will impact goodwill, then earnings – no reduction to intangibles•Changes outside the measurement period will impact earnings, not goodwill.•Changes to valuation allowance will be recorded in income.•Record deferred tax assets on excess tax-deductible goodwill•Transaction costs are expensed as incurred.



IFRS US GAAPFinancial Statement disclosure differences

•The effect of changes in tax rates or laws substantively enacted after the balance sheet date

•Not required

•No specific disclosures relating to intercompany transfers of inventory

•No specific disclosures relating to intercompany transfers of inventory

•Reconciliation between tax expense and pre-tax accounting profit using aggregation of separate reconciliations using individual jurisdiction tax rates.

•Reconciliation between tax expense and pre-tax accounting profit using statutory tax rate


•Disclosure of the effect of changes in tax rates after the balance sheet date is not required.

•Disclose the component of deferred tax assets and liabilities representing the effect of intercompany transfers of assets between taxing jurisdictions with different effective tax rates.

•The IASB will amend IAS 12 to require the use of the statutory rate applicable to the parent company.


Key Differences Between IFRS and US GAAP


Differences Between IFRS and US GAAP – Hot Topics

• Revenue Recognition

• Inventory Reporting

• Business Combinations

• Components of Financial Statements

• Taxes


Inventory Reporting

IFRS US GAAPCosting Methods LIFO is prohibited. LIFO is an acceptable

method.

Measurement Inventory is carried at the lower of cost or net realizable value.

Inventory is carried at the lower of cost or market.

Reversal of Inventory Write Downs

Previously recognized impairment losses are reversed, up to the amount of the original loss.

Any write downs of inventory cannot be reversed.


Accounting for Income Taxes

IFRS Conversion Focuses on:

• Effective tax rate • Cash tax• International taxation• State taxation• Processes and controls


Tax Considerations of IFRS

• Effective tax rate considerations– Differences in pre tax income under IFRS– Income tax uncertainties

• Cash tax considerations– LIFO– Tax accounting methods

• Other considerations– Transfer pricing documentation– Share based payments and other compensation

matters


Tax Considerations of IFRS

• State and Local Taxation• Systems, Processes, and Controls• International Tax Considerations

– Tax Planning– Measurement Concepts– Financial Statement Impact

<Datum> <footer>2008 OFII Tax Conference 47 La Quinta, CA

Questions and Answers

2008 Tax Conference

Documents

Transcript of 2008 Tax Conference