ASC 740 Greater transparency within financial statements
INSIGHT ARTICLE |
The implementation of ACS 740 (formerly FIN48) was designed to provide greater transparency within financial statements regarding tax matters, creating thresholds for financial statement recognition of tax positions taken, or expected to be taken in a tax return.
Registered products including mutual funds, with any U.S. GAAP reporting responsibility, are required to clarify any positions that would be considered uncertain under ASC 740 and FIN48 regulations with respect to positions taken regarding income based taxes.
Why does ASC 740 have an impact on mutual funds that pass through their income to the investors without paying income taxes?
Mutual funds are taxable entities and only avoid U.S. income tax if they meet the strict requirements of Subchapter M of the Internal Revenue Code in each of their tax years. Although many of the earlier uncertainties regarding these requirements have been addressed in tax rulings, regulations and the recent Regulated Investment Company Modernization Act of 2010, the dynamic nature of the fund industry and complexity of securities in which they invest continue to require judgments by fund management on tax return positions which, if not sustained, could trigger taxation of all the fund's net income at corporate tax rates.
Does ASC 740 require a mutual fund or hedge fund to address non-U.S. tax matters?
Yes. For example:
- A fund must consider whether investing in non-U.S. securities constitutes a trade or business in those countries, potentially subjecting the fund to foreign taxes on its income generated there.
- Dividends and interest payments from non-U.S. investments are often subject to foreign tax withholding at statutory rates but with the potential for a refund of part or all of the withheld tax based depending on the applicable double taxation avoidance treaty. Potential liabilities, as ASC 740 represents, need to be reflected in a fund's NAV and only restored with the reclaimed taxes are received.
Because these liabilities relate to taxes that may not have been or may not be collected, the validity of this process seems unclear. The issue at hand is whether a specific tax authority could try to reclaim these withheld amounts, not where they would, and a measurement criteria of the probability that said claim would most likely be successful, that establishes the basis for accountability.
- Many countries recently have imposed capital gains taxes on the sale of securities, equities and/or bonds issued in their respective jurisdictions. The application of capital gains tax may be impacted by numerous client and market driven variables, such as, where and how the security is held in custody, the extent of a fund's ownership interest in an individual issue, and the length of time the assets are held. In some instances, the capital gain tax may exist but taxes have not been collected by the seller or paid by the fund; judgments are necessary regarding the whether the foreign tax authorities can seek restitution of the taxes due.
Capital gains tax applicability may also be affected by local practices. For example, in some countries the applicability of the tax, the calculation methodology used and/or the method for collection may vary by local jurisdiction. There may not be an actual office to remit taxes due, or taxpayers may be required to hire local tax representatives for remittance. This can be more onerous if the calculation of taxes due is based on a relief methodology that does not mirror a fund's accounting practices.
These issues must be evaluated within the framework of ASC 740, a two-step process of recognition and measurement.
- Recognition is the determination as to whether a tax position has met the "more likely than not"; threshold and that the tax position will be sustained upon examination, based on the technical merits of the position.
- A tax position that meets the "more likely than not" recognition threshold, is then measured to determine the amount of tax benefit that will be realized upon settlement with the tax authorities.