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SEC Chief Accountant Guides Funds on Applying FIN 48 to NAV Calculations

In a letter to three prominent fund families, SEC Chief Accountant Conrad Hewitt advised that accounting for tax positions should be performed in accordance with FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, for all of a mutual fund's net asset value ("NAV") calculations. The letter was sent to Fidelity Investments, the Oppenheimer Funds, and Massachusetts Financial Services Company. Richard F. Sennett, chief accountant of the Division of Investment Management, also signed the letter. The SEC officials specifically noted that the guidance is limited to assessing tax positions reflected in NAV calculations subject to the Investment Company Act and should not be applied by analogy in other cases.

Hewitt noted that financial statements prepared in accordance with GAAP are prohibited from using FASB Statement No. 5 on accounting for contingencies for assessing tax positions, and rejected the funds' suggestion that they should not record a tax liability in NAV if no reduction is required by an analysis performed under FAS 5. The SEC officials believe that the accounting for tax positions should be performed in accordance with FIN 48 for all NAV calculations. To do otherwise, they reasoned, could result in the application of two different standards, a practice that not only would be confusing to investors but, more importantly, would leave significant uncertainty as to the value of a fund share.

FIN 48 was written to clarify the accounting for uncertainty in income taxes that are recognized in an enterprise's financial statements in accordance with FASB Statement No. 109 on accounting for income taxes. FIN 48 requires a fund to determine whether a tax position, based on its technical merits, meets the more-likely-than-not recognition threshold that the position will be sustained upon examination. This determination is based on the individual facts and circumstances of that position evaluated in light of all available evidence. FIN 48 requires that a fund assume that a tax position will be examined by the relevant taxing authority that has full knowledge of all relevant information. After determining whether a fund meets the more-likely-than-not recognition threshold, it must measure the amount of the tax benefit resulting from the tax position.

Although FIN 48 was written to provide guidance on financial reporting, it does not address how tax positions should be accounted for in the calculation of NAV for purposes other than financial reporting, such as shareholder transactions. FIN 48 challenges funds because they calculate NAVs much more frequently than they prepare financial statements, which is somewhat unique to the fund industry. For example, open-end funds generally calculate NAV daily in order to effect transactions in their shares.

The SEC understands that there may be instances in which a fund may be required to record a tax liability in its NAV calculation. Hewitt advised funds that they may take a number of steps to assess whether a tax issue exists, whether it results in the recognition of a liability and the amount of that liability. The fund can gather the relevant information to determine the facts and the materiality of a potential tax liability to NAV and whether such liability requires adjusting the NAV. The fund can research authoritative sources in the tax law, such as legislation and statutes, case law and their applicability to the current facts. Funds also can consult with tax advisers. They may also review both their own and other enterprises prior dealings with the taxing authority, and may consult with the taxing authority.

The SEC officials noted that these steps are non-exclusive, and recognized that this process may not be completed on the day that a tax issue is initially discovered. However, they rejected the notion that funds should be afforded a specified period, such as 45 days, in performing their assessment of a potential tax issue.

The Commission expects a fund to exercise reasonable diligence in gathering the relevant information and to adjust NAV accordingly when a tax position does not meet the recognition criterion in FIN 48. A fund is also expected to make every effort to evaluate uncertain tax positions expeditiously and not to unduly delay recording tax liabilities in NAV calculations. Generally, it will not be appropriate for funds to delay recording a tax liability in NAV if they have the relevant information to assess the technical merits of a tax position and conclude that it does not meet the recognition criterion in FIN 48.

Similarly, funds are expected to adopt procedures, which may incorporate the steps listed above, to try to avoid those situations in which they inadvertently find themselves in a position in which they are forced to record tax liabilities to the NAV. These procedures, for example, should ensure that all relevant parties consider tax implications when launching new products, making new investments or making operational changes to a fund. In addition, the SEC expects funds to adequately document the accounting treatment for uncertain tax positions.

Hewitt reminded funds that FIN 48 does not place any limits on the type of evidence that funds can look to in making their determination of the technical merits of a tax position. Finality or certainty of the resolution of a tax matter is not necessary to recognize or measure tax positions. Recognition and measurement of a tax position, including those tax positions in which there is a lack of authority and audit experience in a particular area, should be based on management's best judgment given the facts and circumstances known at the time.

On a separate issue, the SEC officials advised that the notion of past administrative practice in paragraph 7(b) of FIN 48 is limited to widely understood dealings with the taxing authority and should not be extended to situations where a fund's adviser steps up and pays the tax liability for the fund.

FIN 48 solely addresses the accounting for tax uncertainties, and should not be used as a basis for recognizing and measuring gain contingencies as they relate to indemnifications from advisers or other parties. Instead, funds should refer to the recognition criteria in other areas of GAAP when accounting for indemnification receivables. GAAP establishes a probable threshold with respect to the recognition of indemnification receivables.

In this context, the officials noted that an adviser's contractual obligation to indemnify uncertain tax positions would usually be sufficient in demonstrating that the likelihood of recovery is probable. Further, the process of obtaining such a contractual obligation may occur simultaneously while the fund is gathering the relevant information to assess whether a liability should be recorded to NAV. In these circumstances, recognition of an indemnification receivable, to the extent of recovery of the tax accrual, generally would be an acceptable practice. Subsequently, if the uncertain tax position is effectively settled, the SEC cautioned that both the tax accrual and any related indemnification receivable should be derecognized.

James Hamilton