June 28, 2007 Letter to Fidelity Investments, Massachusetts Financial Services Company and OppenheimerFunds, Inc. re: Implementation of FASB Interpretation No. 48
June 28, 2007
Mr. Stephen D. Fisher
Mr. Eric Roiter
Ms. Maria Dwyer
Mr. Scott Huebl
Dear Messrs. Fisher, Roiter and Huebl and Ms. Dwyer:
This letter is in response to your March 28, 2007 letter in which you request interpretive guidance on the implementation of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("Interpretation 48").1 Your letter sets forth issues you believe still need to be addressed to prevent any adverse effects for funds from Interpretation 48 and seeks additional guidance. Specifically, you ask for a provision of adequate time to allow for accurate Interpretation 48 accruals. You also ask for clarification that a fund need not reduce its net asset value ("NAV") in respect of a tax liability when it has been the administrative practice of the fund's advisor or another relevant party to pay or reimburse the fund for errors the advisor or other party has made.
1. Timing of application of Interpretation 48 to uncertain tax positions
You indicate that funds may inadvertently find themselves in a position in which they are forced to make an immediate Interpretation 48 determination but are unable to assess either the threshold recognition issue or the appropriate amount to accrue within the one-day timeframe uniquely applicable to funds. You indicate that a fund may be unable to make an immediate assessment for one of two reasons. First, there may be a complete lack of authority and audit experience in a particular area. Second, even if there is legal authority on a given issue, it may be impossible within the one-day time constraint of NAV calculations to determine how to apply that authority to the existing fact pattern in assessing whether the more-likely-than-not2 recognition threshold in Interpretation 48 has been met. You indicate that if Interpretation 48 is applied to require the NAV reduction before complete information is available and the facts can be fully analyzed, one or more additional adjustments to NAV likely will be necessary as more facts are learned. You indicate that in the meantime, shareholders will be paying and receiving prices that are artificial due to inaccurately calculated, difficult to estimate tax liabilities that had to be determined in haste.
You request that funds be allowed to incorporate into the implementation of Interpretation 48 some flexibility as to the time period for them to perform the necessary Interpretation 48 analysis. When a tax uncertainty is first noticed, you propose to allow a fund to make a determination of the tax liability pursuant to FASB Statement No. 5, Accounting for Contingencies ("Statement 5"). If the fund believes no accrual is required under that approach, you propose to afford the fund a period until the end of the quarter but in any event no less than 45 days to resolve the issue prior to applying Interpretation 48.
We understand that Interpretation 48 continues to pose challenges for funds because they calculate NAVs much more frequently than they prepare financial statements for periodic reports, which is somewhat unique to the fund industry. For example, open-end funds generally calculate NAVs daily in order to effect transactions in their shares. A tax liability recorded to the NAV of an open-end fund has the direct economic consequence of reducing NAV, thereby impacting shareholders purchasing and redeeming fund shares on the day in which the tax liability is recorded. In addition, the total value of a shareholder's investment in a particular fund will be reduced by the amount of the tax liability recorded to the NAV. Closed-end funds calculate NAVs to facilitate trading of their shares, to make periodic repurchases, to offer shares through dividend reinvestment plans, to make new offerings, and for other purposes. Therefore, it is of utmost importance that NAVs are calculated accurately, and that tax positions, among other things, are accurately reflected in NAVs.
Interpretation 48 was written to clarify the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. It 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. Moreover, Interpretation 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 Interpretation 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 (e.g., for shareholder transactions). You suggest that a fund should not record a tax liability in NAV if no reduction is required by an analysis performed under Statement 5. We disagree. We believe that the accounting for tax positions should be performed in accordance with Interpretation 48 for all NAV calculations. To do otherwise could result in application of two different standards, a practice that not only would be confusing to investors but, more importantly, could leave significant uncertainty as to the value of a fund share. Additionally, we note that financial statements prepared in accordance with generally accepted accounting principles ("GAAP") are prohibited from using Statement 5 for assessing tax positions.
We understand there may be instances in which a fund may be required to record a tax liability in its NAV calculation. A fund may take one or more of the following steps to assess whether a tax issue exists and whether it results in the recognition of a liability, as well as the amount of that liability:
These steps are not meant to be an all-inclusive list. Depending on the nature and extent of the tax issue, we recognize that this process may not be completed on the day that a tax issue is initially discovered. We do not believe, however, that it is appropriate to afford a specified period for a fund in performing its assessment of a potential tax issue, such as the 45-day period suggested in your letter. We expect 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 Interpretation 48. We also expect a fund to make every effort to evaluate uncertain tax positions expeditiously and not unduly delay recording tax liabilities in NAV calculations. Generally, it is not appropriate for a fund to delay recording a tax liability in NAV if a fund has the relevant information to assess the technical merits of a tax position and concludes that it does not meet the recognition criterion in Interpretation 48.
We remind funds that Interpretation 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.3 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 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.
We also expect funds to adopt appropriate procedures, which may incorporate the steps listed above, to try to avoid those situations in which funds inadvertently find themselves in a position in which they are forced to record tax liabilities to the NAV.4 These procedures should, for example, ensure that all relevant parties consider tax implications when launching new products, making new investments, or making operational changes to a fund. In addition, we expect funds to have adequate documentation supporting the accounting treatment for uncertain tax positions.
2. Clarification regarding past administrative practice
You state that in some cases where a fund may be required to accrue a tax liability under Interpretation 48, the fund advisor or another party may step in and agree to pay this tax liability, even though there may be no obligation to do so. You propose extension of the concept of past administrative practice, as described in paragraph 7(b) of Interpretation 48 and as clarified in the ICI Letter, to an advisor's (or other relevant party's) practice of making a fund whole for tax liabilities or other harm the fund has suffered as a result of the advisor's or other party's actions or inactions. Thus, to the extent an advisor or other party had a general disposition, upon discovery of an error or other issue, to make a fund whole, you propose the fund could consider this in determining whether to reduce its NAV.
We, however, note that the notion of past administrative practice in paragraph 7(b) of Interpretation 48 is limited to widely understood dealings with the taxing authority and should not be extended to an advisor's (or other relevant party's) practice of making a fund whole. Interpretation 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 advisors (or other relevant 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, by analogy to EITF Issue No. 01-10, Accounting for the Impact of the Terrorist Attacks of September 11, 2001, which in turn refers to AICPA Statement of Position 96-1, Environmental Remediation Liabilities ("SOP 96-1"). This EITF Issue states:
Based on this guidance, we note that an advisor's (or other relevant party's) contractual obligation to indemnify uncertain tax positions generally would be sufficient in demonstrating that the likelihood of recovery is probable. The process of obtaining a contractual obligation to indemnify uncertain tax positions 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 acceptable practice. Subsequently, if the uncertain tax position is effectively settled5, both the tax accrual and any related indemnification receivable should be derecognized.
The guidance contained in this letter is limited to assessing tax positions reflected in NAV calculations subject to the Investment Company Act of 1940 and the rules thereunder and should not be applied by analogy in other cases. Further, this guidance does not express any conclusions regarding your accounting analysis on other issues presented in your letter. We hope this response is helpful to you and others in the fund industry. If you have any further questions related to this matter, please contact Toai P. Cheng in the Division of Investment Management at 202-551-6918 or Nili Shah in the Office of the Chief Accountant at 202-551-3255.
Richard F. Sennett
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