Transcript Historical Perspective

FIN 48
and other developments with
potential to impact a captive’s
financial statements
March 12, 2008
Daniel Kusaila
Kate Westover
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Agenda
Part One: What’s with us now?
• Fin 48
Part Two: What is coming?
• Treasury Decision 9329
• FAS 157
• FAS 159
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Part One: FASB Interpretation No. 48 (FIN 48)
- Agenda
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Initial Pronouncement
Pre-FIN 48
Overview
Steps in FIN 48
Classification
Interest & Penalties
Disclosures
Common Concerns for Captives
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FASB Interpretation No. 48
(FIN 48)
• FIN 48- FASB’s latest pronouncement in
accounting for income taxes.
–Released July 13, 2006
• FIN 48 interprets FAS 109
• Intent is to decrease the diversity in
accounting for uncertainty in income tax
financial statement positions.
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Pre-FIN 48
• Uncertainties in tax positions were handled
under SFAS 5, Accounting for
Contingencies.
• SFAS 5 included income taxes as well as
all other taxes (excise, property, franchise,
sales and use, employment and others).
• FIN 48 amends SFAS 5, which is no longer
applicable to income taxes.
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Overview
• Prior to recognizing the benefit of a tax
position for financial reporting purposes,
the tax position must be more-likely-thannot (MLTN) of being sustained solely on
its technical merits (excluding detection
risk)
• Tax positions recognized are reported at
the largest amount that is MLTN to be
sustained
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Overview
• Effective Date for Years
Beginning on or After
December 15, 2006
• ALL GAAP FINANCIAL
STATEMENTS
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Overview
FASB Staff Position FIN 48-2
(Feb. 1, 2008)
– Defers the effective date for all nonpublic
enterprises for fiscal years beginning after
December 15, 2007.
– Nonpublic consolidated entities of public
enterprises applying GAAP are not eligible
for deferral.
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FIN 48
• FIN 48 applies to all tax positions within
SFAS 109
– Does not apply to non-income taxes
• Tax positions:
– Deductions taken (or expect to be taken)
– Taxable income excluded
– Conclusions not to file an income tax return
• STATE TAXES!
– Conclusions that an entity or transaction is
tax-free
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Steps in FIN 48
1. Identify Tax Position
1. Bottom-up approach
1. Identify all material positions for each “open” year
2. Top-down approach
1. Broad approach
2. Determine the Unit of account- Purposely left
Undefined
1. When applying the recognition and measurement,
unit of account may be the tax position or an
element thereof
2. Similar tax positions should have similar units of
account
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Steps in FIN 48
3. Evaluate the position for recognition
1. In order to recognize any amount of the benefit,
the position must be MLTN of being sustained
1.The position will be examined
2.The examiner will have full knowledge of
all relevant info
3.Evaluation based solely on technical
merits
4.No offset or aggregation of positions
5.Should assume resolution in the court of
last resort
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Recognition
• Highly certain tax positions
– Clear tax law
– Will prevail opinion
– Extent of evidence and documentation requires judgment
• Evidence & Documentation of Uncertain tax positions:
– Depends on the nature of the position
– Legislation, statutes, legislative intent, regulations, rulings
& case law
– Third party experts
• Tax Opinions
• Other oral or written advice
– Role of the auditor
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Step 4: Measurement of Benefit
• A tax position is reported at the
largest amount of benefit that is
greater than 50% likely of being
realized
• “Cumulative Probability Assessment”
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Step 4: Measurement of Benefit Continued…
Example… Loss Reserve was understated
Estimated
Outcome
$
100
$
75
$
50
Individual
Probability (%)
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40
Cumulative
Probability (%)
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60
100
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Step 4: Measurement of Benefit Continued…
• Chart is not required
• Realistically, making the estimates in
the chart would often be extremely
difficult.
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Step 4: Measurement of Benefit Continued…
Used Incorrect Discount Factors:
Book
Tax Basis
FIN 48 Basis
500
400
300
1,000
(500)
(100)
1,000
(400)
(100)
1,000
(300)
(100)
Income
400
500
600
Tax Rate
34%
34%
34%
136
170
204
Reserves
Premium
Underwriting
GAA
Tax Payable
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Step 4: Measurement of Benefit Continued…
Current Tax Expense
Current Income Tax Payable
As Filed
FIN 48
170
204
170
170
FIN 48 Liability
Deferred Tax Expense
Deferred Tax Asset
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68
68
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Step 4: Measurement of Benefit Continued…
Perm (Tax Exempt Interest):
Book
FIN 48
100
Current Tax Expense
Current Tax Payable
Tax Basis
0
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20
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Step 5: Classification
• Differences between the (as-filed)
tax basis and the FIN 48 basis
usually result in the recognition of a
liability.
• FIN 48 liabilities are long term
unless expected to be settled within
one year
• May need to reduce NOL
Carryforwards or refunds
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Step 6: Accrue Interest
• FIN 48 provides that classification
of interest is an accounting policy
– Interest expenses or disclosed under
income taxes
• Accrue interest on the difference
between the FIN 48 and the as-filed
as the interest would be due under
the law
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Step 7: Disclosures
• Description of open tax years by jurisdiction
• Qualitative and Quantitative disclosures of
unrecognized benefits that are reasonably
possible of changing
• Tabular reconciliation of beginning and ending
balances of unrecognized benefits
• Amount of unrecognized benefits that will change
the rate rec
• Classification and amount of interest and
penalties
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Step 7: Example Disclosure
The following example illustrates disclosures
about uncertainty in income taxes. In this
illustrative example, the reporting entity has
adopted the provisions of this Interpretation
for the year ended December 31, 2007:
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Step 7: Example Disclosure continued…
The Company, or one of its subsidiaries, files income tax returns in the
U.S. federal jurisdiction, and various states and foreign jurisdictions.
With few exceptions, the Company is no longer subject to U.S. federal,
state and local, or non-U.S. income tax examinations by tax authorities
for years before 2001. The Internal Revenue Service (IRS)
commenced an examination of the Company’s U.S. income tax
returns for 2002 through 2004 in the first quarter of 2007 that is
anticipated to be completed by the end of 2008. As of December 31,
2007, the IRS has proposed certain significant adjustments to the
Company’s transfer pricing and research credits tax positions.
Management is currently evaluating those proposed adjustments to
determine if it agrees, but if accepted, the Company does not
anticipate the adjustments would result in a material change to its
financial position. However, the Company anticipates that it is
reasonably possible that an additional payment in the range of $80 to
$100 million will be made by the end of 2008.
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Step 7: Example Disclosure continued…
The Company adopted the provisions of FASB Interpretation No. 48, Accounting for
Uncertainty in Income Taxes, on January 1, 2007. As a result of the implementation
of Interpretation 48, the Company recognized approximately a $200 million increase
in the liability for unrecognized tax benefits, which was accounted for as a reduction
to the January 1, 2007, balance of retained earnings. A reconciliation of the beginning
and ending amount of unrecognized tax benefits is as follows:
Balance at January 1, 2007
Additions based on tax positions related to the current year
Additions for tax positions of prior years
Reductions for tax positions of prior years
Settlements
Balance at December 31, 2007
(in millions)
$370,000
10,000
30,000
(60,000)
(40,000)
$310,000
Included in the balance at December 31, 2007, are $60 million of tax positions for
which the ultimate deductibility is highly certain but for which there is uncertainty
about the timing of such deductibility. Because of the impact of deferred tax
accounting, other than interest and penalties, the disallowance of the shorter
deductibility period would not affect the annual effective tax rate but would
accelerate the payment of cash to the taxing authority to an earlier period.
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Step 7: Example Disclosure continued…
The Company recognizes interest accrued related to unrecognized
tax benefits in interest expense and penalties in operating
Expenses. During the years ended December 31, 2007, 2006, and
2005, the Company recognized approximately $10, $11, and $12
million in interest and penalties. The Company had proximately
$60 and $50 million for the payment of interest and penalties
accrued at December 31, 2007, and 2006, respectively.
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Common Concerns for Captives
1.
2.
3.
Meeting Qualifications of Insurance
Qualifying as a Reciprocal for IRS purposes
Dividends & Tax Exempt Interest
1.
2.
4.
Loss Reserve Discounting
1.
2.
5.
6.
7.
Correct Lines of Business
Correct IRS Factors
Advanced Premium
Controlled Group Elections
Tax exempt status
1.
2.
8.
Mutual fund dividends
Tax exempt bonds
501(c)(15)
Private Letter Ruling
State Income Taxes (including unitary)
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Promising News
IRS has stated FIN 48 workpapers
will be viewed as audit workpapers.
As such, the IRS will not ask for
FIN 48 workpapers upon IRS audit.
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Part Two: The Future
• Treasury Decision 9329
• FAS 157
• FAS 159
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Treasury Decision 9329
• Issued June 2007
– Finalizes IRS Regulations Sec. 1.6012-2
• Every domestic life and non-life insurer
filing a US federal income tax return
must attach an annual statement
– NAIC blank
– 953(d) companies required to file a “pro-forma”
annual statement
– No guidance but potential SAP requirement
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FIN 157
• Purpose: establish framework for
measuring “fair value” and expanding
disclosures about fair value
measurements
– No new methodologies for measuring fair
value, but new applications that may
change current practice
– Not insurance company specific, but
significant questions surrounding
application of insurance transactions
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“Fair Value” Definitions
• Prior to Statement No. 157 multiple
possible definitions, limited guidance as to
how to apply them in GAAP
• Objective is increased consistency
• Retains/reinforces concept that “fair value”
is based on an “exchange price”
• Any gain or loss resulting from
reclassification reported as a cumulative
adjustment to retained earnings.
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Exchange Price
• The price in an “orderly transaction
between market participants” for
purposes of
– Sale of assets
– Transfer of liabilities
• Must be derived from a transaction in
“the principal or most advantageous
market for the asset or liability”
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Fair Value Accounting
• Uses the exchange price based on a
hypothetical transaction at the
measurement date
– The price that would be received if the
asset sold or liability transferred (exit
price), not the price paid to acquire the
asset or assume the liability (entry price)
• Must be market not entity based
– Establishes a “market hierarchy”
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Market Hierarchy
Level 1: Observable price i.e. market participant
assumptions independent of the reporting entity
Level 2: Observable inputs (pricing model)
Level 3: Unobservable i.e. reporting entity’s own
assumptions (requires extensive disclosures)
Reporting entity may not ignore Level 1 and 2
information that is reasonably available without
undue cost and effort
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Risk
• Inherent in valuation techniques
• Fair value measurement must reflect
adjustment for risk
– Assuming allowance for risk included in the exit
price
• Also reflect impact of restrictions on
the sale or use of the asset
– Assuming market participants would consider
the restriction when pricing the asset
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How Could This Impact Insurers?
• Affirms previous statements
– 115 Investments in Debt and Equity Securities
– 133 Derivative Instruments and Hedging Activities
– 107 Fair Value of Financial Instruments
(disclosures of)
• Clear application to accounting for invested
assets but what about reserves/policy
assets?
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FASB Concept Stmt No. 6
• Elements of Financial Statements
– Fair value measurement reflects current market
participant assumptions about the future inflows
associated with an asset (increase in economic
benefits) and future outflows associated with a
liability (reduction in economic benefit)
• Implication that reserves must reflect future
interest earnings and future service fees
– Fair value will be the NPV of expected cash flows
under the policy or reinsurance agreement
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Recording Discounted Reserves
• The commutation price, assuming a
market for sale of the liability
• Will the IRS then require a discount to the
fair value reserve amount, when
calculating taxable income?
• Effective date of FIN 157
– Applies to financial statements issued for
fiscal years beginning after Nov. 2007
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FIN 159
• Fair Value Option for Financial Assets and
Liabilities
• Permits entities to choose to measure
financial instruments at fair value.
• Objective: mitigate volatility in reported
earnings ….without adoption of complex
hedging provisions
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FIN 159 does not apply to:
• Investment in subsidiary that entity is
required to consolidate
• Interest in VIE
• Employers’ and plans’ obligations for
pension and other post retirement benefits
• Lease obligations
• Deposit liabilities
• Financial instruments that are component of
shareholder’s equity
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FIN 159 does apply to:
• Non-financial insurance contracts and
warranties that the insurer can settle by paying
a third party to provide the goods and services
• The Fair Value Option permits the entity to
choose to measure eligible items at fair value at
specified election dates
– Report unrealized gains and losses on items
for which the fair value option has been
elected
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The Fair Value Option
• Is applied to “entire instruments”, not to
portions of instruments
• Is irrevocable
• Applies to entities with fiscal years
beginning after Nov. 2007
– Provided the entity has elected to apply the
provisions of FAS 157
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Questions for the
Panel Members?
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Thank you
panel members for your
participation today.
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This program fulfills 1/3rd of the teleconference
requirement for the completion of the Associate
in Captive Insurance (ACI) designation.
It also counts as 100 minutes of continuing
education (2 CPE credits) for CPAs via ICCIE’s
certification through the National Association of
State Boards of Accountancy (NASBA), as well
as 2 continuing education credits for ACI
designation recipients.
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