Copyright 2010 Gale Group, Inc.All Rights ReservedASAPCopyright 2010 A.M. Best Company, Inc. Best’s Review
June 1, 2010
Pg. 85(2) Vol. 111 No. 2 ISSN: 1527-5914
Make no mistake: most tax entanglements arise from basic errors. Here’s how to avoid common problems; Regulatory/Law: Deferred Taxes
In last month’s Best’s Review, an historical overview of StatutoryAccounting Principles 10 and Accounting Service Codification 740, accounting for income taxes, was addressed. The second part will reporton some common errors that insurers may encounter when reviewing income tax provisions and how to prevent them.
Miscomputations stem from two basic errors. The first–which is easier to understand but perhaps more difficult to discover–is mathematical errors. The second is technical errors, which typically occur because of a lack of understanding of the underlying principles of accounting for income taxes.
The best ways to prevent these errors are to have a clear work program in place for accounting for income taxes and to make sure that the people working on the provision have adequate training.
Mathematical errors typically manifest themselves as formula errors embedded in an Excel spreadsheet. These errors are often difficult to correct because the formulas and various links may be very complicated. Often, numerous spreadsheets are linked together, and trying tofind a formula error could be like trying to find a needle in a haystack. Test all of your formulas to ensure that they are working properly, and be aware that there are numerous software products on the market that compute income tax provisions.
One of the more common technical errors is mistaking when to book a deferred tax asset as a carry-forward. These items are sometimes overlooked because they are carried forward from a previous period or they are not computed correctly. Some common carry-forward items that create deferred tax assets that are sometimes missed are: net operating loss carry-forwards; capital loss carry-forwards; and alternative minimum tax credits.
Net operating losses can be carried forward 20 years and carried back two years to offset prior year income (for life insurance companies, it is forward 15 and back three). The amount of the net operatingloss must be multiplied by the tax rate in order to determine the amount of the deferred tax asset.
For example, if a company has a $1 million net operating loss, that loss gives rise to a potential $350,000 asset ($1 million times theeffective tax rate of 35%). Once the asset is determined, it is thennecessary to compute how much of the asset should be admitted under SSAP 10.
Capital losses can be carried forward five years to offset future capital gains and back three years to offset prior capital gains for all corporations, Again, in order to determine the amount of the deferred tax asset, you must multiply your capital loss carry-forward by the effective tax rate and then compute how much of the asset may be admitted.
Alternative Minimum Tax Credit
Another item that is often misunderstood is the alternative minimum tax credit. Alternative minimum tax credits are generated in years in which a company is subject to alternative minimum tax.
To the extent the company is subject to alternative minimum tax ina given year, they generate alternative minimum tax credits. The credits can be used to reduce regular tax to the extent that the regulartax exceeds the AMT in a future year. The credit does not expire.
Unlike the net operating loss carry-forward and the capital loss carry-forward, the alternative minimum tax credit does not have to be multiplied by the effective tax rate. This is because the credit is already tax-affected–the entire credit represents a component of the deferred tax asset. So, for example, if a company paid $200,000 in alternative minimum tax in 2008, they would have a deferred tax asset of $200,000 coming into 2009. Similar to the other carry-forward discussions, the deferred tax asset then must be tested for admissibility under SSAP 10.
Unrealized Gains and Losses
Errors also can occur in the treatment of unrealized gains and losses. For SSAP purposes, common and most preferred stocks are usually marked-to-market at the end of the period. Depending on how a company’s portfolio is performing, the company will have either unrealized gains or losses.
Net unrealized capital gains will give rise to a deferred tax liability, because when the securities are sold they generate additional tax liability. Conversely, net unrealized capital losses give rise toa deferred tax asset because, upon liquidation of the securities, this will reduce the company’s overall liability.
Complications can arise when a company has “other than temporary impairment.” This was seen occurring often over the past year because of the sharp decline in the stock market. Many clients had holdings in Lehman Brothers, which they wrote off as “other than temporary impairment.”
This resulted in a current charge to the income statement. Neitherthe current nor the deferred tax position of the company will change, because the impairment is not a realized loss for tax purposes.
However, the current tax provision will require an adjustment to remove the “other than temporary impairment” loss (your taxable incomewill be increased).
For SSAP purposes, the deferred tax impact is recognized in surplus on the “change in net deferred income tax” line.
Deferred Tax Assets
The last area that often causes confusion is with the admissibility of deferred tax assets under SSAP 10.
The regulators came up with a mechanical test that they felt was objective to determine the admissibility of the deferred tax assets.
Gross deferred tax assets are admitted to an amount equal to the sum of federal income taxes paid in prior years that can be recovered through loss carry-backs for existing temporary differences that reverse by the end of the subsequent calendar year, and the amount of gross deferred tax assets expected to be realized with one year of the balance sheet date, or 10% of statutory capital.
Regulators made some adjustments to SSAP 10 and promulgated SSAP 10R in December, 2007, and created some additional confusion and challenges this past year.
SSAP 10R made three modifications to SSAP 10.
First, it has added a valuation allowance concept (similar to the GAAP requirement) for all filers. Second, it also allows companies that meet certain risk-based capital requirements to elect to apply a more liberal admissibility test.
Lastly, significant additional disclosures such as the character of deferred tax assets and deferred tax losses, the valuation allowance, and risk-based capital apply to all insurers Filing statutory statements.
One of the best ways to avoid errors is to have a clear understanding of the process that needs to take place in order to prepare your provision.
There are four fundamental steps in the process of preparing your income tax provision: Prepare your current federal income tax expense; prepare the deferred federal income tax expense; determine the gross deferred tax asset/liability; and compute the nonadmitted deferred tax asset.
* The Story: Insurers can easily make avoidable errors when dealing with deferred tax assets.
* The Background: Mistakes arise when spreadsheets are incorrectlyformulated or the preparer is not well-acquainted with tax regulations.
* The Way Forward: Having a thorough understanding of intricate tax rules will help insurers steer clear of potentially costly problems.
Contributor Paul Dougherty is partner-in-charge of the Insurance Tax Practice at Amper, Politziner & Mattia LIP. He can be reached at Dougherty@amper.com
June 24, 2010