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15.6 Interest and penalties
Publication date: 31 Mar 2023
us Income taxes guide
Generally, taxing authorities assess interest on any underpayment of tax, but only assess penalties if a disallowed position fails to meet certain minimum thresholds of support.
15.6.1 Interest
If a benefit claimed on a tax return does not qualify for financial reporting recognition, the benefit essentially constitutes a loan from the government and therefore results in an interest charge. Consequently, the basis for an interest accrual should be the difference between the tax position recognized in the financial statements and the amount claimed (or expected to be claimed) in the tax return. The commencement of an interest accrual should be in accordance with the relevant tax law. For example, in the US federal tax system, a calendar-year corporation generally starts accruing interest two and one-half months after the end of the tax year for which the position was taken on a tax return. Interest should be accrued each period prior to ultimate resolution of the uncertainty.
15.6.1.1 Interest income on uncertain tax positions
While ASC 740 does not reference interest income specifically, we believe that interest income related to uncertain tax positions should be accounted for in the same manner as interest expense. That is, interest income should be recognized over the time period in which it accrues under the applicable tax law. Example TX 15-5 and Example TX 15-6 demonstrate concepts associated with recording interest income related to uncertain tax positions.
EXAMPLE TX 15-5
Recording interest income on a transfer pricing tax position
Recording interest income on a transfer pricing tax position
Company X has taken a position related to transfer pricing. In Jurisdiction A, Company X has recorded a liability for an unrecognized tax benefit for $100 and will record interest expense at a rate of 5% per year. However, under competent authority between Jurisdiction A and Jurisdiction B, Company X believes that it is more-likely-than-not that it will be able to amend its tax return for Jurisdiction B to reduce its taxable income for the related tax position that was not sustained in Jurisdiction A. In addition, Company X would be entitled to interest income on the overpayment of tax for the amended return in Jurisdiction B at a statutory interest rate of 6%.
What interest should Company X record?
Analysis
We believe that Company X should record interest expense on the liability of $5 ($100 × 5%) in Jurisdiction A and also record interest income of $6 ($100 × 6%) in Jurisdiction B.
EXAMPLE TX 15-6
Recording interest income on overpayments of tax
Recording interest income on overpayments of tax
Company A has determined that a tax position resulting in a $1,000 tax benefit qualifies for recognition and should be measured. After considering all relevant information, management believes that there is a greater than 50% chance that all of the benefit will be realized. To stop interest charges from accumulating in the event that it loses the issue, Company A makes a payment to the taxing authority for the $1,000. Under the laws of the jurisdiction in which this uncertainty exists, Company A will receive interest income from the taxing authority if the position is ultimately sustained.
Should Company A record any interest income on the $1,000 payment?
Analysis
Yes. Because $1,000 is the largest amount of benefit that is greater than 50% likely to be realized upon settlement, the $1,000 payment would be considered a pre-payment to the taxing authority and recorded as an asset. Given that the settlement of the amount recorded in the financial statements would entitle Company A to interest income on the $1,000 pre-payment, this interest income should be accrued by Company A.
15.6.2 Penalties
Certain situations trigger the potential imposition of penalties. Although it is the filing of a return that creates a legal obligation, the penalty should be recorded in the period in which the tax position is taken. Example TX 15-7 illustrates the impact past practice may have on the decision to accrue a penalty.
EXAMPLE TX 15-7
Considering a taxing authority’s past practices to determine whether a tax penalty should be accrued
Considering a taxing authority’s past practices to determine whether a tax penalty should be accrued
Company X has filed tax returns in Jurisdiction Y and has determined that after the application of ASC 740’s recognition and measurement criteria, $100 of a tax benefit claimed on its tax return in Jurisdiction Y cannot be recognized for financial reporting purposes.
The relevant tax law in Jurisdiction Y provides for a 50% penalty assessment on any unpaid balance that exists after the original due date of the tax return (this amount is in addition to the requirement for interest to be paid on the unpaid balance). It is widely known that in Jurisdiction Y, the taxing authority routinely charges interest for underpayments, but historically has only assessed the 50% penalty if fraud is suspected or if the expectation that the tax position will be sustained based upon its technical merits is remote.
Company X has concluded that the tax position at issue did not constitute fraud and that the position has more than a remote chance of being sustained based on its technical merits.
How should Company X account for the penalty under the relevant tax law in Jurisdiction Y?
Analysis
In this instance, the taxing authority appears to have established a de facto minimum statutory threshold for assessment through its historical administrative practice of only assessing the 50% penalty under specified conditions.
Consistent with ASC 740-10-25-7, which provides for the consideration of past administrative practices and precedents that are widely understood, we believe that the administrative practice in regard to penalties should be considered. As a result, Company X should not accrue the 50% penalty.
15.6.3 Classification of interest and penalties
In accordance with ASC 740-10-45-25, the classification of interest on the liability for unrecognized tax benefits as either a component of income tax expense or interest expense is an accounting policy election that is required to be disclosed. Penalties are also allowed to be classified as a component of income tax expense or another expense classification (e.g., selling, general & administrative expense) depending on the reporting entity’s accounting policy. See FSP 16.4.2 for additional information.
ASC 740 does not address the classification of interest income. We believe that it would be consistent to classify both interest income and interest expense as either a component of tax or of pretax income.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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