What it means
Tax law is rarely clear on every point, so companies often take a reasonable view on matters such as how to split a purchase price, where profit is earned, or whether an expense qualifies for a deduction. If an authority later disagrees, the company owes extra tax plus interest and possibly penalties.
An uncertain tax position is any treatment where that risk is meaningful. US accounting standards handle this in two steps.
First, the company decides whether the position is more likely than not (above a 50% chance) to be sustained if the authority examines it with full knowledge of the facts. If it is not, none of the benefit can be recorded.
Second, if the position passes that test, the company measures how much benefit to recognise. It records the largest amount that has a greater than 50% chance of being kept after settlement, and the rest is held as a liability, often called a reserve.
International standards use a related approach under a different interpretation, so a group reporting under both should expect small differences. The reserve is not a prediction of what will certainly be lost; it is a measured estimate that is reviewed every reporting period.
It is reduced when the position is settled, when the time limit for the authority to examine the return runs out, or when new information makes success more likely. For managers outside finance, the practical point is that aggressive tax planning leaves a visible mark in the accounts.
Auditors ask for evidence, such as advice from tax advisers and prior rulings, and the company must disclose a reconciliation of the reserve each year. Weak support for a position can therefore cost money even before any tax authority has looked at it.
In practice
Real-world examples
Example 1
A software group moves its intellectual property into a subsidiary in a low-tax country and deducts royalty payments back to the parent. Its advisers think the arrangement is defensible but not certain. The group books a reserve for the portion of the tax saving it may have to repay.
Example 2
A construction company treats $2,000,000 of costs on a long project as immediately deductible rather than spreading them over several years. The tax authority has challenged similar claims in other industries. The finance team measures the likely outcome and sets aside a reserve for the difference.
Example 3
A retailer claims a credit for hiring in a designated area, but the paperwork for some employees is incomplete. The accountants judge that some of the credit would be allowed and some would not. They recognise only the amount that is more likely than not to stand.
Think of it
Imagine playing a board game where you bend a rule to gain an advantage, but you know the referee might spot it later and penalise you. Instead of spending that bonus cash immediately, you keep some money aside just in case the referee forces you to return it.
Formula
Calculation
Recognised benefit = Largest amount with a cumulative probability above 50% of being sustained
Liability for uncertain position = Total tax benefit claimed - Recognised benefit
A company claims a deduction on its return that saves $400,000 of tax. Its advisers assess the possible outcomes if the authority examines the issue: the full $400,000 is kept with a 30% chance, $300,000 is kept with a 35% chance, $200,000 is kept with a 25% chance and nothing is kept with a 10% chance. The chance of keeping at least $400,000 is 30%, which is below 50%. The chance of keeping at least $300,000 is 30% + 35% = 65%, which is above 50%. So the recognised benefit is $300,000, and the liability = 400,000 - 300,000 = $100,000.Case study
Seen in the real world
Lakeshore Components is an illustrative, fictional manufacturer that sells to customers in several countries. Its tax director took a position that allocated more profit to a low-tax subsidiary, which reduced the group tax bill by $750,000 in the year.
The auditors asked for the evidence. The tax director had internal pricing studies but no external advice, and the auditors judged that the position had roughly a 55% chance of being kept in full and a meaningful chance of losing a third of the benefit.
After discussion the group recognised $500,000 of the benefit and recorded a $250,000 liability. In the illustrative sequel, a tax authority later examined the return and accepted two thirds of the position, which matched the reserve closely and avoided a surprise charge to profit.
Watch out
Common mistakes
- Treating a reserve as an admission that the company did something wrong, when it is simply an estimate of risk on a judgement call.
- Recognising the whole tax saving because the company believes it is right, when the test is the likelihood of the authority agreeing after examination.
- Ignoring interest and penalties on the possible shortfall, which are usually accounted for as well.
Questions
People also ask
What does more likely than not mean?
It means a greater than 50% probability that the tax position will be upheld if examined, assuming the authority has all the relevant facts.
When can a reserve be released?
When the position is settled with the authority, when the period in which the authority can examine the return ends, or when new facts raise the likelihood of success enough to change the measurement.
Do private companies have to follow these rules?
Generally yes if they prepare accounts under the same standards, although the disclosure requirements for them can be lighter.