All the news about Apple’s international tax situation, a significant uncertainty that they and many other companies face, presents a great opportunity to review how uncertainties and the big questions they pose should be disclosed.
Developing disclosures about uncertainties is never simple. One reason for this complexity is how many areas they can affect in a 10-K or 10-Q. The key places to focus are:
Risk Factors
Financial statements – GAAP contingency disclosures
MD&A – possible known trend disclosures
The key disclosures will be in the three above items, and that is where we will focus for now. It is important to remember though that other areas could be involved. Disclosure might be included for example in legal proceedings in Item 3 (which would generally be similar to the financial statement disclosures but would likely include more details) and perhaps even the business description in Item 1 if the uncertainty was a significant general development.
Risk Factor Disclosure
S-K Item 503(c) contains this requirement:
(c) Risk factors. Where appropriate, provide under the caption “Risk Factors” a discussion of the most significant factors that make the offering speculative or risky. This discussion must be concise and organized logically.
Clearly a material uncertainty could fall into this disclosure requirement. Apple talked about tax issues in their most recent Form 10-Q Part II Item 1A disclosure (emphasis added):
The Company could be subject to changes in its tax rates, the adoption of new U.S. or international tax legislation or exposure to additional tax liabilities.
The Company is subject to taxes in the U.S. and numerous foreign jurisdictions, including Ireland, where a number of the Company’s subsidiaries are organized. Due to economic and political conditions, tax rates in various jurisdictions may be subject to significant change. The Company’s effective tax rates could be affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or their interpretation, including in the U.S. and Ireland. For example, in June 2014, the European Commission opened a formal investigation of Ireland to examine whether decisions by the tax authorities with regard to the corporate income tax to be paid by two of the Company’s Irish subsidiaries comply with European Union rules on state aid. If the European Commission were to conclude against Ireland, it could require Ireland to recover from the Company past taxes covering a period of up to 10 years reflective of the disallowed state aid, and such amount could be material.
The Company is also subject to the examination of its tax returns and other tax matters by the Internal Revenue Service and other tax authorities and governmental bodies. The Company regularly assesses the likelihood of an adverse outcome resulting from these examinations to determine the adequacy of its provision for taxes. There can be no assurance as to the outcome of these examinations. If the Company’s effective tax rates were to increase, particularly in the U.S. or Ireland, or if the ultimate determination of the Company’s taxes owed is for an amount in excess of amounts previously accrued, the Company’s financial condition, operating results and cash flows could be adversely affected.
Financial Statement Disclosures
After the risk factor, where perhaps we use an “everything including the kitchen sink” approach, Apple goes further. In the notes to the financial statements they included this disclosure. Note here that ASC 450 dealing with contingencies and the three levels of probability — probable, reasonably possible and remote — would apply, along with guidance about uncertain tax positions. Here, along with disclosure about other tax issues, Apple discloses the issue again (check out the last paragraph in particular).
Note 5 – Income Taxes
As of June 25, 2016, the Company recorded gross unrecognized tax benefits of $7.6 billion, of which $2.8 billion, if recognized, would affect the Company’s effective tax rate. As of September 26, 2015, the total amount of gross unrecognized tax benefits was $6.9 billion, of which $2.5 billion, if recognized, would have affected the Company’s effective tax rate. The Company’s total gross unrecognized tax benefits are classified as other non-current liabilities in the Condensed Consolidated Balance Sheets. The Company had $1.5 billion and $1.3 billion of gross interest and penalties accrued as of June 25, 2016 and September 26, 2015, respectively, which are classified as other non-current liabilities in the Condensed Consolidated Balance Sheets.
Management believes that an adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs. Although timing of the resolution and/or closure of audits is not certain, the Company believes it is reasonably possible that its gross unrecognized tax benefits could decrease (whether by payment, release or a combination of both) in the next 12 months by as much as $800 million.
On June 11, 2014, the European Commission issued an opening decision initiating a formal investigation against Ireland for alleged state aid to the Company. The opening decision concerns the allocation of profits for taxation purposes of the Irish branches of two subsidiaries of the Company. The Company believes the European Commission’s assertions are without merit. If the European Commission were to conclude against Ireland, the European Commission could require Ireland to recover from the Company past taxes covering a period of up to 10 years reflective of the disallowed state aid. While such amount could be material, as of June 25, 2016 the Company is unable to estimate the impact.
One of the areas the SEC focuses on in reviewing contingency disclosures is the “reasonably possible” probability level. In this situation disclosure is required and an amount must be disclosed if it can be estimated. If it can’t be estimated disclosure is still required.
MD&A
And, lastly MD&A requires disclosure of known trends and uncertainties. The language in S-K Item 303 includes this requirement:
(a)(3)(ii) Describe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations. If the registrant knows of events that will cause a material change in the relationship between costs and revenues (such as known future increases in costs of labor or materials or price increases or inventory adjustments), the change in the relationship shall be disclosed.
Here is an excerpt from Apple’s MD&A.
On June 11, 2014, the European Commission issued an opening decision initiating a formal investigation against Ireland for alleged state aid to the Company. The opening decision concerns the allocation of profits for taxation purposes of the Irish branches of two subsidiaries of the Company. The Company believes the European Commission’s assertions are without merit. If the European Commission were to conclude against Ireland, the European Commission could require Ireland to recover from the Company past taxes covering a period of up to 10 years reflective of the disallowed state aid. While such amount could be material, as of June 25, 2016 the Company is unable to estimate the impact.
Uncertainty disclosures are never easy, and with all the areas that can potentially be involved, a place to be very careful!
As always, your thoughts and comments are welcome!