The Financial Statement Side: Reserves are not Optional

Unregistered tax exposure is an accounting problem before it is a controversy problem. A company that knows it has nexus and has not filed has a liability that must be evaluated for recognition and disclosure in its financial statements, and the applicable framework differs depending on the tax.

Income Tax Exposure — ASC 740

State income and franchise tax positions fall within ASC 740, including the subtopic governing uncertain tax positions. A decision not to file a return in a state where the company may have nexus is itself a tax position, and it is subject to the same two-step framework as any other. The company must first determine whether the position is more likely than not to be sustained on examination, assuming the taxing authority has full knowledge of all relevant facts and that the position will be examined. Only positions clearing that recognition threshold may be reflected in the financial statements; if the threshold is not met, no benefit is recognized and a liability for the unrecognized tax benefit is recorded.

For positions that do clear recognition, measurement follows: the benefit recognized is the largest amount that is more than fifty percent likely to be realized on ultimate settlement, evaluated using a cumulative probability approach. Interest and penalties on the exposure are accrued as well, classified consistently with the company's stated policy. The resulting liability for unrecognized tax benefits is disclosed in the tax footnote, including a tabular reconciliation of the beginning and ending balances, and where applicable, a statement about positions for which the total amount could change significantly within twelve months.

Critically, ASC 740 does not permit a company to avoid recognition on the theory that the state is unlikely to discover the issue. Detection risk is expressly excluded from the analysis. The assumption is examination with full knowledge of the facts. "They will probably never find us" is not a supportable basis for declining to reserve.

Sales Tax Exposure — ASC 450

Uncollected sales and use tax is not an income tax and therefore falls outside ASC 740. It is a loss contingency accounted for under ASC 450. The recognition test is different and, in practice, often easier for the state to satisfy: an estimated loss is accrued when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated.

Where a company has established nexus, made taxable sales, and not collected tax, the probable threshold is generally met, the obligation exists as a matter of law, independent of whether the state has yet asserted it. The remaining question is measurement. If a range of loss can be estimated and no single amount within the range is a better estimate than any other, ASC 450 requires accrual of the low end of the range, with disclosure of the additional exposure up to the high end. If a loss is reasonably possible rather than probable, no accrual is required but disclosure of the nature of the contingency and an estimate of the possible loss (or a statement that such an estimate cannot be made) is.

The measurement analysis for sales tax should account for several offsetting and aggravating factors: taxability by product, service, and state; available exemption or resale certificates that can be obtained retroactively from customers; whether the tax can realistically be collected from customers after the fact or must be absorbed by the company; the gross-up effect where the company absorbs the tax; statutory penalties and interest by state; and states in which the exposure is de minimis relative to the cost of compliance.

The SEC Has Enforced This: Hudson Highland Group

Companies sometimes treat unremitted sales tax as a purely state-level problem — a matter between the company and the revenue departments. For SEC registrants, it is also a securities disclosure and internal controls problem. In January 2011, the SEC instituted a settled administrative proceeding against Hudson Highland Group, Inc., a Nasdaq-listed staffing company, arising out of its handling of approximately $3.9 million in state and local sales tax that its North American segment failed to collect and remit over a period running from 2003 to 2007. Hudson agreed to pay a $200,000 civil penalty, neither admitting nor denying the findings.

The charges were not tax charges. The SEC found violations of the books-and-records and internal accounting controls provisions of the Exchange Act — Sections 13(b)(2)(A) and 13(b)(2)(B) — on the basis that the company's books did not accurately reflect its sales tax liabilities and that it lacked controls sufficient to provide reasonable assurance that transactions were recorded as necessary to prepare financial statements in accordance with GAAP. The Commission's order describes the company's own tax personnel suggesting that reserves of roughly $150,000 to $200,000 be discussed for sales tax exposures in at least four states, and no additional reserve being recorded in response. During the investigation the staff had also signaled, through a Wells notice, a theory that the company's periodic reports for 2006 and the first quarter of 2007 lacked adequate narrative disclosure of the sales tax matters in MD&A.

Two lessons follow for public companies and for private companies contemplating a transaction or an IPO. First, identifying the exposure and fixing it prospectively is not a defense to the accounting failure that preceded it; Hudson had self-identified the issue, remediated its systems, and paid the states in full before the order issued. Second, the reserve is the control. The failure the SEC described was a failure to record and track the liability — precisely the ASC 450 analysis discussed above. A documented nexus study, a quantified exposure, a booked reserve, and a disclosed contingency are what convert a state tax problem into a managed one. Pursuing VDAs without doing that work first leaves the securities exposure fully intact.

How a VDA Changes the Reserve Analysis

This is where the controversy strategy and the accounting intersect, and it is the point most often missed. A VDA does not merely reduce cash out the door; it converts an estimate into a measurable amount and, in most cases, reduces it.

Before a VDA, the sales tax accrual under ASC 450 has to contemplate all open periods, because no return has been filed and the statute has not run. Penalties have to be included in the estimate, because there is no basis to assume they will be waived. The range of reasonably possible loss is wide, and the disclosure has to reflect that.

Once a VDA is executed, the lookback period is contractually fixed and the penalties are contractually waived. The accrual can be measured against the agreed periods rather than all periods, penalties come out of the estimate, and the range narrows to something close to a point estimate. Both the recorded liability and the disclosed upper bound typically decline — and the change is supportable, because it rests on an executed agreement rather than a judgment about detection risk. The same logic applies to income tax positions resolved through a state's voluntary disclosure program: an agreement that closes prior periods supports releasing the associated unrecognized tax benefit.

Timing matters for reporting. Whether the effect of a VDA is reflected in the current period or the subsequent period depends on when the agreement is executed relative to the balance sheet date and whether the arrangement is a recognized or non-recognized subsequent event. Companies pursuing multiple state VDAs in parallel should coordinate the expected execution dates with the reporting calendar and discuss the treatment with their auditors in advance rather than after the fact.

Auditors will also read the VDA correspondence. Voluntary disclosure files, nexus studies, and the reserve workpapers are standard requests in a financial statement audit, and inconsistencies between the nexus dates used in the reserve analysis and those disclosed to the states are difficult to explain. The nexus determination should be made once, documented once, and used consistently for the registration, the VDA submissions, the income tax filings, and the reserve.