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One of our readers recently emailed us with a question about the application of the new Schedule UTP to deferred tax assets. The question is straightforward enough: must uncertain positions involving deferred tax assets be reported on Schedule UTP and, if so, when must they be reported? The explanation, thanks to confusion created by several examples in the final Schedule UTP instructions, is anything but straightforward. Let’s start with a little background.
A deferred tax asset arises from a timing difference between the treatment of an item on a taxpayer's financial statements and the treatment of that same item for tax purposes. In the case of a deferred tax asset, a deduction is typically taken into account for financial statement purposes before the deduction is taken into account for tax purposes. Thus, the value of the future tax benefit that is expected to be realized is recorded on the taxpayer's financial statements as an asset. Conversely, a deferred tax liability occurs where an item of income (which will eventually produce a tax liability) is taken into account for financial statement purposes before it is taken into account for tax purposes.
A common example of a deferred tax asset is a net operating loss that occurs in year one and may be carried forward to later years to offset taxable income. Until the item is used to offset income in a later year, the prospective value of that item is recorded on the taxpayer's financial statement as a deferred tax asset. For instance, a $100 NOL would be recorded as a $35 deferred tax asset on the company’s balance sheet. However, whether or not a taxpayer must report on Schedule UTP the tax position arising from a deferred tax asset depends on whether there is anything about the anticipated future tax benefit the taxpayer considers to be uncertain. The uncertainty can arise over the timing of the deduction (e.g., should it be deducted currently or over time) or over its merits (i.e., is a deduction taken over time allowable under the tax law). For example, assume the following cumulative probability analysis for the $35 deferred tax asset under FIN 48
Possible Estimated OutcomeIndividual Probability of Occurring (%)Cumulative Probability of Occurring (%)$35 deduction
(i.e., 100% of the benefit likely to occur on settlement)
(80% settlement likelihood)
(60% settlement likelihood)
The cumulative probability analysis under FIN 48 allows the taxpayer to currently recognize in its financial statement the largest amount of benefit greater than 50% that is likely to be realized in settlement. In the above example, the taxpayer would recognize a tax benefit of $21 (equivalent to 60% of the value of the deferred tax asset) for financial reporting purposes and record a reserve for the remaining $14 (equivalent to the remaining 40% that is considered uncertain).
The new Schedule UTP generally requires a taxpayer to report federal income tax positions for which the taxpayer has recorded a reserve on its financial statements and has taken that tax position on a return. This is simple enough to understand in the case of a current deduction or loss, but what about in the case of a deferred tax asset? In that situation, a reserve may be established in year one, but the deduction or loss will carry forward into subsequent years either partially or entirely. Unfortunately, the Schedule UTP instructions confuse rather than clarify the reporting requirement.
Example 6 of the instructions refers to a situation where there is uncertainty over the timing of a deduction, namely whether to claim it entirely in 2010 or amortize it over five years. Because of uncertainty over current deductibility, the taxpayer reserves for the full amount of the anticipated timing benefit in when it claims the current deduction in 2010. However, because the example contemplates only a temporary item based on the timing of a deduction, the only reserve required is for deficiency interest that might be owed if it is subsequently determined that the deduction must be amortized rather than deducted currently.
Here’s where confusion sets in. The example states that only the 2010 position must be reported because that is the only year in which a reserve is recorded. This is incorrect. Interest, which accrues with the passage of time, would only begin to run from March 15, 2011, the due date of the 2010 return. Hence, there should be no reporting requirement for 2010, because the reserve for interest would not be recorded until 2011. Indeed, the taxpayer’s potential interest liability for 2011 would not even be calculable until the close of that year.
A second flaw in the example is the explanation that no reporting is required for post-2010 years because no reserve is recorded in those years. If the example had been drafted correctly, it would have noted that the taxpayer is required to report the item on Schedule UTP in 2011 when the reserve is first recorded, but not thereafter because no amortization deductions are claimed in the subsequent years. (That being said, it is not entirely clear from the example whether the Service expects taxpayers to disclose annual additions to reserves for interests, which would occur in the subsequent years.)
Example 7 involves an amortization deduction, the allowability of which is uncertain. Based on this uncertainty, the taxpayer records a reserve in 2010 for the tax positions it expects to take during the five-year amortization period. (The deferred tax asset portion of the deduction is represented by the amortization deductions for 2011 through 2014). The example explains that the taxpayer must report the position on Schedule UTP for each year of the amortization period. This is consistent with the two-tier requirement because the reserve was already recorded in year one and the deduction is claimed each year.
Where Example 7 runs into difficulty is with the statement that it would make no difference if the reserve was recorded each year in which the tax position is taken rather than in year one when the expenditure was incurred. The problem with this analysis is that it would be inconsistent with financial reporting requirements, which would require that the reserve be reported at the time the uncertainty arose in year one and the deferred tax asset is established. (Although it is possible that the reserve might increase or decrease in subsequent years, such changes to a previously recorded reserve do not trigger a new reporting of a tax position according to the instructions.) Therefore, the “result would be the same” language at the end of Example 7 is superfluous and serves only to confuse.
Finally, Example 9 of the instructions, which concerns the creation and use of an NOL, also perpetuates the misinterpretation in the Schedule UTP instructions of financial reporting requirements. The example posits a deduction claimed in 2010 that increases the taxpayer’s NOL carryforward to 2011. Although the deduction claimed in 2010 is an “adjustment to a line item and therefore, under the instructions, “a tax position taken on a tax return,” the example states that no reporting requirement arises because the deduction did not give rise to a tax benefit in 2010 for which a reserve needed to be recorded. It goes on to note that once the reserve is recorded in 2011, both tiers of the two-tier requirement have occurred and the position must be reported on Schedule UTP.
In reality, the taxpayer would likely have set up the NOL deduction as a deferred tax asset in 2010 and booked it that year under financial reporting requirements. Therefore, the example’s assumption that the reserve would not be recorded until 2011 would, once again, appear erroneous, as is the advice that no reporting would be required until 2011. Because both the recording of a reserve and the claiming of a tax position occur in 2010, that is the first year that should be reported on Schedule UTP.
So What’s The Rule of Thumb?
Notwithstanding the mistakes in the examples, a good rule of thumb is to follow the simple directive in Announcement 2010-75, 2010-41 IRB 428 in the figuring out the Schedule UTP reporting requirements for deferred tax assets. The Announcement amplifies the explanation of tax positions to be reported in the instructions by adding that a tax position must be reported on Schedule UTP “once (1) a reserve for a tax position is recorded and (2) a tax position is taken on a return regardless of the order in which those two events occur.” [Emphasis added.]
In other words, taxpayers should report a deferred tax item on Schedule UTP each year the item is claimed on the tax return, provided that a reserve has been recorded for the item. In the case of a temporary item (e.g., Example 6), where the issue is whether to deduct currently or deduct over time, the interest reserve will be recorded in the year after the tax position is taken and that will drive the reporting requirement.
On the other hand, in the case of a permanent item, where the issue concerns the validity of a tax position (e.g., Example 7), the reserve will always be recorded up front when the current deduction is taken unless the position becomes uncertain after the year in which the deduction was claimed based on an extraordinary event such as a change in the law. In other words, the reporting requirement will almost always arise in year one when both the reserve is recorded and the tax position is taken. However, there may be subsequent years when no reporting of the deferred tax asset is required under Schedule UTP. For example, if an NOL is reported in year one and a reserve is recorded for the loss that same year as will likely be required where a deferred tax asset is created, the taxpayer must report the loss on Schedule UTP both in the year the loss arises and in each subsequent income year to which the loss is carried forward. For a company that is not consistently profitable, this means that the same item will be reportable in profitable years but not in loss years.
There is one final caveat to this discussion worth noting, which brings up an issue we have talked about before. The final Schedule UTP and instructions unfortunately retain the requirement to report tax positions for which no reserve is taken but which the taxpayer expects to litigate. Theoretically, this could include a deferred tax asset, just as it might include a current tax item.
Therefore, what does a taxpayer do when it does not record a reserve but nonetheless expects to litigate an issue involving a deferred asset? Because the reporting requirement only begins once a tax position is taken and a reserve is recorded, should we also assume that this translates into a reporting requirement when the tax position is taken and an expectation to litigate arises where no reserve is ever recorded? This is a difficult question to answer because the final instructions provide no guidance on how a corporation documents its expectation to litigate.
In Announcement 2010-75, the IRS merely states that it “expects that a corporation would continue to document its decision in the same way as it substantiates any decision not to record a reserve in its financial statements.” Thus, on one hand, early written substantiation of an intention to litigate an issue would seem prudent, particularly if a taxpayer wants to later contend that documents created at that time are impressed with work-product protection under the “anticipation of litigation” standard. On the other hand, it may also precipitate a reporting requirement earlier than might otherwise be required, not to mention provide an inducement to investigate and potentially challenge issues that should probably never be controverted in the first place.
Thanks to TaxAccountingNews.com for the pointer.