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Tax Ramifications of IFRS By George L. White American Institute of Certified Public Accountants, Washington, DC International Financial Reporting Standards (IFRS) has been a major preoccupation of financial accountants in recent years, as the Securities and Exchange Commission (SEC) has led the movement (“convergence”) away from Generally Accepted Accounting Principles (GAAP) toward the new international standard. In November, 2008, the SEC released a lengthy document entitled, “Roadmap for the Potential Use of Financial Statements Prepared in Accordance With International Financial Reporting Standards by U.S. Issuers.” The roadmap sets out several goals that must be reached before IFRS becomes mandatory for U.S. public companies. The adoption date for IFRS is currently set for 2014. However, the presidential election of 2008 has made that 2014 date look a little less certain. The roadmap was the initiative of a Republican-led SEC, chaired by Christopher Cox, former member of the House of Representatives from California. Chairman Cox's term expired with the inauguration of President Obama, who has nominated Mary Schapiro to succeed Cox. At her confirmation hearing before the Senate Banking Committee, Ms. Schapiro sounded a cautionary note about continuing to pursue Mr. Cox's initiative. Ms. Schapiro indicated that she was concerned over a perceived looser set of standards under IFRS, as well as a lack of consistency among the versions of IFRS already adopted by some foreign countries. In the background here, of course, is the wide-spread conviction that the current global financial crisis owes much to a culture of non-regulation at the SEC whose recent reputation has not been helped by its seeming indifference to the depredations of Bernard Madoff. But securities regulators and financial accountants are not the only stakeholders concerned with the advent of IFRS. Taxpayers, tax practitioners, and the IRS will all be challenged by the change-over to an entirely new system of financial reporting. Beginning earlier this year, the IRS Large and Midsize Business Division (LMSB) hosted a five-part series of roundtables focusing on the principal issues that IFRS poses for tax administration. The five roundtables covered the following topics: • E&P Rules • Transfer Pricing • Inventory Issues, especially LIFO • Revenue Recognition • Change of Accounting Methods (CAMs) E&P Rules The E&P issues raised by IFRS seem primarily centered on foreign corporations owned by U.S. shareholders. The E&P of foreign corporations is critical in the determination of (1) the deemed paid foreign tax credit (§902) and (2) the amount of Subpart F income (§951 et seq.). At first glance, the determination of E&P of foreign corporations would seem unrelated to the adoption of IFRS because E&P is a tax concept that has no real relation to its financial accounting cousin, Retained Earnings. However, the linkage is there, even if not immediately apparent. It lies in the common starting point for many foreign corporations in determining their E&P: books and records. For many foreign corporations, books and records may or may not be kept on U.S. GAAP; they might be on a local version of GAAP. Nevertheless, a GAAP starting point, even if not strictly computed according to U.S. GAAP, is a familiar foundation for taxpayers and tax practitioners alike. Complications are almost certain to arise when the foundation is shifted from GAAP to IFRS. The adjustments needed to reach E&P might all look familiar but, if the starting point is different, the end result will inevitably be different, too. Think of a baseball analogy. Every schoolboy knows the distance from home plate to the rubber on the pitcher's mound is 60’ 6”. What if the distance were shortened by 2 or 3 feet, wouldn't that distort the results? It certainly would make the pitcher's job a lot easier. Years ago, it is said that former Brooklyn Dodger great, Don Newcombe, used to do precisely that. Newcombe was a hard-throwing right-hander who arrived in the big leagues in 1949, part of the second wave of black players after Jackie Robinson broke the color line in 1947. On dusty summer days, Newcombe would kick dirt over the rubber as the game progressed, until it was no longer visible to the batter or the home plate umpire. Newcombe would inch forward inning-by-inning. By game's end, he would be throwing from 57’. Talk about “adding a few feet” to your fastball! The problem of identifying comparable GAAP and IFRS figures would be eased if companies maintained reconciliations of the two reporting systems. But that does not appear likely to happen, once the transition period is over. After that, GAAP will be an obsolete system and companies will have no need to maintain GAAP figures. Transfer Pricing Unlike the E&P issue where the impact of IFRS is indirect, IFRS affects transfer pricing in a very direct way. The impact derives from the Code and regulations. Section 482 authorizes Treasury to re-allocate income and deductions among related taxpayers; Regs. §1.482-1(b) prescribes an arm's length standard for transactions between related taxpayers. For the purpose of documenting compliance with the arm's length standard regarding transfer pricing issues, the method of choice for most taxpayers is the comparable profits method provided in Regs. §1.482-5. The use of the comparable profits method is totally dependent upon information found in competitors' published financial statements. (Obviously, taxpayers have no access to competitors' tax returns.) Complications in using competitors' published financial statements are certain to arise when, as has already occurred, IFRS is adopted by the home countries of some competitors before the United States. Comparability will be compromised, if not lost completely. In addition, comparability analyses also rely on multi-year averages. When, as is certain to occur, the earlier years in such analyses are still on GAAP while the most recent are on IFRS, comparability may be impossible. Comparability over multi-year averages would be eased considerably if there were annual reconciliations of GAAP to IFRS figures. However, as noted above, that does not appear likely to happen, once the transition period to IFRS is over. After that, GAAP will be an obsolete system and companies will have no need to maintain GAAP figures. In addition to the tax reporting challenges arising out of transfer pricing, there is also the financial reporting issue. Several participants at the LMSB roundtable noted that the transfer pricing issue is the single most significant item in the FIN 48-mandated disclosure of uncertain tax positions. Inventory Issues, Including LIFO Since the late '30s, the last-in, first-out (LIFO) method of valuing inventory has been a fixture of the income tax system.1 For an equally long period, LIFO has also been recognized as a permissible inventory valuation method under GAAP.2 As a historical note, §472 was enacted, in part, because Treasury had consistently declined to approve the use of LIFO under its general authority under §471 to approve inventory methods. One of the by-products of the legislative process enacting §472 was the condition attached to its use for tax purposes. In order to use LIFO for tax purposes, taxpayers must also use LIFO in its financial statements.3 The LIFO method is, as is well-known, not permitted under IFRS. If, as many have predicted, the SEC mandates the use of IFRS in, say, 2014, the practical impact on LIFO taxpayers is that they will no longer be able to use LIFO for tax purposes because they will be unable to comply with the conformity requirement of §472(c). Switching from LIFO to another method will result in a positive adjustment to income. Taxpayers requesting IRS permission to change accounting methods, involving positive adjustments, are generally allowed to spread the adjustment over four taxable years (Rev. Proc. 2008-52, 2008-36 I.R.B. 587). A possible complication to the IFRS timetable terminating LIFO is Congressional action. In the last Congress, Rep. Rangel (D-NY), chairman of the Ways and Means Committee, introduced a comprehensive corporate tax reform bill (H.R. 3970) that included LIFO repeal. Under Congressional “pay-go” budget rules, tax reductions must be paid for by tax increases. The estimated revenue pick-up from LIFO repeal was $106B which would help pay for overall corporate rate reductions. Why would Congress consider LIFO repeal if repeal seems inevitable under IFRS? The reason lies in the same Congressional “pay-go” budget rules. An increase in tax revenues arising out of the operation of existing law, e.g., higher tax revenues from AMT resulting from inflation, cannot be considered as “paying for” tax reductions. In other words, for Congress to be able to count the increased tax revenue from LIFO repeal, those increases must result from Congressional action. If Congress were to wait until LIFO is wiped out by IFRS, Congress would forever lose the opportunity to use those increased tax revenues to pay for tax reductions. A second inventory issue concerns §263A (“Unicap”). Since the Tax Reform Act of 1986, taxpayers with inventories have been required to include certain direct and indirect production costs in inventory valuations. For taxpayers in existence when §263A went into effect, i.e., years beginning after December 31, 1986, inventories had to be revalued to reflect the greater absorption of production costs. For most, if not all, taxpayers, this revaluation was effected by starting with a base of GAAP-valued inventories and layering on the additional production costs mandated by §263A. Roll the clock forward to the IFRS era, when taxpayers will have to re-do these calculations using IFRS-valued inventories as the base. If IFRS-valued inventories yield different values (either higher or lower) from GAAP-valued inventories, the end result will be a different value for ending inventory and cost-of-good sold (COGS). For LMSB's agents, this could present a formidable challenge, as they try to understand how inventory valuations under IFRS might differ from GAAP. Revenue Recognition In many ways, the challenges raised by the issue of revenue recognition are the most unsettled of the IFRS-related issues. That's because the challenges are not really IFRS-related. When it comes to revenue recognition, IFRS has been trumped by a “Discussion Paper” (“Paper”) released jointly in late December, 2008, by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). The Paper is part of series of joint projects between the two bodies intended to promote the “convergence” of GAAP and IFRS. In brief, the Paper proposes an entirely new set of standards for revenue recognition, standards that are different from both GAAP and IFRS. The Paper critiques GAAP as having too many standards, and IFRS not enough. The Paper is the first step in developing a proposed standard; before that happens, an Exposure Draft will be released for public comment. For those of us who learned about the accrual system in Accounting 101, the Paper will come as a distinct surprise. In place of our familiar notion equating revenue recognition with an earnings event such as delivery of the product, the Paper proposes something decidedly different, an approach that focuses on the balance sheet. This approach owes much to the current emphasis on fair-value accounting.4 The proposed standard for revenue recognition is based upon the net increase in the seller's contract asset, i.e., either an increase in the asset side or a decrease in the liability side. The measurement of revenue also introduces new standards: a bifurcation of the various components of a contract. For example, a typical sales contract for a product includes a component for warranty repairs. The Paper proposes to separate the revenue from each component (goods and services) and to separately recognize the revenue from each component. For the service component, the revenue recognition event will be deferred until the warranty obligation is satisfied. (A deferral of service component income would be a departure from GAAP where no bifurcation is allowed.) A deferral regime would raise potential tax issues.5 Under Rev. Proc. 2004-34, a limited deferral of service income is permitted, so long as the deferral conforms to the taxpayer's financial statement treatment.6 Any new deferral under the Paper would represent a departure from GAAP and current tax reporting. Change of Accounting Methods Section 446(e) requires a taxpayer to obtain permission from IRS before changing its tax accounting method. Change of accounting methods (CAM) has been the most contentious area of tax accounting in recent years.7 Interestingly, none of the dispute involves IFRS. Instead, the controversy has centered on the proposal of the former Chief Counsel to overhaul the IRS's process for handling applications for CAMs. Under the rubric of “working smarter,” the Chief Counsel proposed to drastically reduce the number of CAMs requiring advance approval. The details of his proposal are spelled out in Notice 2007-88, 2007-46 I.R.B. 993. The ABA has been generally supportive of Notice 2007-88,8 the AICPA has opposed it.9 In his exit remarks upon leaving his post at IRS, the Chief Counsel seemed to take umbrage at this opposition.10 As for the connection between IFRS and CAMs, it is as obscure as between IFRS and E&P. Yet the connection is there and is a matter of concern to LMSB. Basically, it stems from the interplay of two factors. The first is the requirement in §446(e) discussed above; the second is the practice of many taxpayers, as a matter of convenience, to conform their tax accounting methods for many items to their book methods. If IFRS causes book methods to change and taxpayers want to continue to conform book and tax methods, the statute requires taxpayers to obtain IRS approval to change their tax methods. The statutory mandate is clear. What is not so clear is whether taxpayers will seek the necessary approval from IRS, and whether LMSB's agents will even know if changes have occurred. As was the case with E&P, the concern of LMSB focuses on a shifting starting point. Schedule M-3, of course, reconciles “book-to-tax” but what if “book” changes and the changes go undetected. In other words, how will LMSB know if the M-3 reconciliation is accurate if the starting point shifts? One suggestion has been to add a schedule to M-3 to require a preliminary reconciliation of GAAP to IFRS, but that suggestion has not been well-received by LMSB. One reason may be that, once IFRS is adopted, GAAP will go the way of analog TV, it will simply disappear. Assuming taxpayers do comply with the statutory mandate and request IRS approval to change methods, IRS will be faced with a range of practical problems (not least of which may be a significant increase in CAM requests). By way of comparison, when §263A became law and taxpayers had to request permission to change inventory valuation methods to comply with Unicap, IRS was inundated with CAMS (Form 3115). One account had it that as many as 3500 Unicap-related 3115s were submitted following the statutory change. IRS could process the IFRS-related 3115s using the traditional advance consent procedure. Alternatively, as a way of dealing with the anticipated flood of 3115s, IRS might consider adopting some kind of automatic procedure. One possible approach using the automatic procedure would be to handle all IFRS-related CAMs on a “global” basis, i.e., without regard to the underlying separate CAMs resulting from IFRS. However, a “global” basis may not be feasible. The underlying CAMs resulting from IFRS could cover a range of methods, from E&P to inventories, to revenue recognition. It would seem desirable, from an IRS point-of-view, to handle each of these separately. If an automatic procedure were to be adopted, whether on a “global” or discrete basis, certain modifications to the Revenue Procedure11 covering automatic changes would seem necessary. For taxpayers under examination, there are only limited periods during which they can use the automatic procedures (“window periods”).12 The purpose of limited access (“scope limitations”) is to prevent taxpayers from “gaming” the system by sitting on a known impermissible method until an agent picks it up. That purpose would seem inapplicable to IFRS-related changes, since the changes won't be known by taxpayers until IFRS is adopted. Accordingly, one recommendation made at the roundtable was to waive the scope limitations of Rev. Proc. 2008-52. Another recommendation made at the roundtable was to consider greater flexibility in the §481 spread periods. The current spread periods are four years for a positive, and one year for a negative, §481 adjustment.13 The notion for greater flexibility is that some taxpayers may wish to take a positive adjustment all in one year, in order to avoid keeping track of small amounts. On the other hand, an adjustment, such as giving up LIFO, may be so large as to require a longer spread period. Conclusion When (if) GAAP is superseded by IFRS, perhaps the major non-technical issue facing all stakeholders (taxpayers, tax practitioners. academics, IRS, et al.) is the need for training. Many stakeholders can afford to put off training until the implementation of IFRS becomes more certain. IRS, however, cannot afford to wait. For IRS and its field agents, the need is imminent. That's because some U.S. taxpayers have already adopted IFRS for their financial reporting. These are the U.S. subsidiaries of foreign issuers whose home countries, e.g., Canada, have adopted IFRS. IRS estimates that, at present, there are about 30 such U.S. taxpayers. For more information, in the Tax Management Portfolios, see White, 570 T.M., Accounting Methods -- General Principles, and in Tax Practice Series, see ¶3530, Methods of Accounting. 1 §472. 2 See Accounting Research Bulletin No. 43, SEC Accounting Bulletin No. 58. 3 §472(c). 4 FSAB Statement No. 157, Fair Value Measurements. 5 “Proposed Accounting Model Could Change Construction Income Recognition,” 2009 TNT26-4 (2/11/09). 6 Rev. Proc. 2004-34, 2004-1 C.B. 991, §5.02(3) 7 See Brown letter to IRS, Jan. 18, 2008, 2008 TNT 15-50; Sheppard, “Should All Accounting Method Changes be Automatic?,” Tax Notes, Mar. 12, 2007, p. 1193. 8 See ABA letter to IRS, July 15, 2008, 2008 TNT 138-21. 9 See AICPA letter to IRS, Jan. 31, 2008, 2008 TNT 25-34. 10 The Chief Counsel said “groups both in and outside the IRS placed their selfish personal interest above the good of tax administration,” 2009 TNT 9-4 (1/15/09). 11 Rev. Proc. 2008-52, 2008-36 I.R.B. 587. 12 Id., §§4 and 6. 13 Id., section 5.04.

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