01/27/2010

Fin 48 Complicates Yearend Audit Process

A 4-year-old accounting rule is finally catching up to the hedge fund industry.

At issue is the Financial Accounting Standards Board's Interpretation No. 48, better known as Fin 48, which provides guidance on accounting for uncertain tax liabilities. Adopted by FASB in 2006, Fin 48 initially applied only to publicly traded companies. But starting with the 2009 tax year, the rule's reach was expanded to limited partnerships and private investment vehicles.

As a result, many fund managers and their accountants are just now coming to terms with the complicated provision. What they're discovering is this: Certain investment gains that didn't necessarily constitute taxable events in the past now must be booked as liabilities pending a review by the IRS or other tax authority. That, in turn, is putting a dent in net asset values.

"Some people believed that Fin 48 adoption would not be a big deal for hedge funds and private equity because they typically are not subject to federal income tax as a partnership," said Craig Eaton, a partner at accounting and consulting boutique Moody, Famiglietti & Andronico in Tewksbury, Mass. "They're now finding out that Fin 48 is more far-reaching."

Fin 48 was introduced to limit the wiggle room companies have in accounting for uncertain tax liabilities - profit or income that may or may not be deemed taxable by the IRS or state tax agency. The rule says that when in doubt, a possible tax obligation should be treated as a liability until the government says otherwise.

Many fund managers, along with their accountants and tax attorneys, are now scrambling to identify any transactions that "more likely than not" will result in tax payments. Fin 48 applies to U.S. hedge funds and offshore accounts that invest in certain U.S. assets.

"There's a finite number of soft spots with Fin 48, but like with any new rule, the beginning is usually a little rough," said Jonathan Schmeltz, a financial-services tax partner at Grant Thornton in New York. "You won't hear the same buzz about it after five years, but right now there's a lot of looking over the shoulder as to what others are doing."

One area of particular concern for U.S. managers is capital gains on securities traded in certain overseas markets, including China, India, Brazil and Australia. In some cases, these markets lack the mechanism to accurately record such transactions.

In the past, hedge funds enjoyed wide discretion in accounting for these gains - and in most cases, they were not booked as tax liabilities. Now, fund managers in many cases have to treat such gains as taxable and hold reserves against the liabilities until the IRS or other tax authority makes a final determination. The immediate effect of this is to push down a fund's net asset value, to the detriment of managers and investors alike.

"Its impact has been significant from the standpoint of added complexity of audits and also NAV calculations," said Joe Pacello, a tax principal of audit firm Rothstein Kass in Roseland, N.J.

Fin 48 also imposes added burdens on certain offshore funds that invest in the U.S. stock market. In particular, the IRS is threatening to audit offshore vehicles that hold dividend-paying stocks through related total-return swaps - instruments the IRS believes have been used to avoid paying taxes on dividends.

Pacello said some offshore funds may have to file "protective" tax returns in order to limit their liability to the last three years. Otherwise, he said, the funds could be on the hook for years' worth of back taxes. "Many fund managers have been caught slightly off-guard by the magnitude of Fin 48 issues," he said.

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