The COVID-19 crisis will negatively impact investment fund returns with tax losses expected to be a common phenomenon.
Can these tax losses help funds rebound in 2021? HSBC Securities Services will take a deeper look at the value of tax losses and how they may help investment funds when market values rebound.
Tax Losses and Value Recognition – Background
Withholding tax is typically applied to dividend and interest income without any deductions for expenses, leaving tax on such income to be, in almost all cases, a tax charge or liability. The capital return on an asset can, however, be a gain or a loss meaning that Capital Gains Tax (CGT) can lead to either a charge on a capital gain being levied or a credit allotted in circumstances where there is a capital loss.
Jurisdictions do not generally give a tax refund where a taxpayer has incurred a capital loss. Instead, they often allow such losses to be carried forward (and sometimes back for a limited period) to offset future capital gains. Determining whether it is appropriate to recognise tax losses in the fund price or statutory accounts can be a complex area and one which requires careful judgement.
Complexity of Recognition of Tax Losses
The main accounting standards, International Financial Reporting Standards (IFRS) (IAS 12) and the United States Generally Accepted Accounting Principles (GAAP) (ASC 740) require, with only very limited exceptions, the recognition of tax charges or liabilities. The hurdle for recognition of deferred tax credits or assets, particularly where the entity is in an overall net tax credit or tax asset position is considerably higher. For both accounting standards, the recognition criteria is broadly the same with a net tax asset position being recognised where it is more than 50 per cent likely1 that such an asset can be used.
The recognition of net tax asset positions is one of the more complex and subjective areas of tax accounting. In circumstances where the amount of tax assets are material in the context of a funds’ NAV or statutory accounts, the recognition of such assets should be carefully considered and be reasonable to help ensure fair treatment of customers who may enter and leave the fund at different times.
Tax Accounting Policy Considerations
The approach to the valuation of Tax Losses should be defined in the Fund’s Tax Accounting Policy and applied as part of the Fund’s Operating Model. In the current COVID-19 environment where tax losses would be expected to be commonplace, the recognition of such losses may be the most pressing issue to consider, with consideration given to whether the ‘more than 50 per cent likely’ threshold for recognition is met. In the post COVID-19 world, when markets rebound, it will also be beneficial to continue to closely monitor tax losses to ensure that such losses are recognised at the appropriate time in fund pricing and statutory accounts.
The following considerations would typically be expected to be included in the Fund’s Tax Accounting Policy in respect of losses:
- The nature of the tax losses and the events that need to occur to enable those losses to be used. Understanding how the losses can be used is key, as only then can an assessment be made as to whether the events required to use the losses are likely to occur; e.g. tax losses which can only be set against future tax gains will only have value if there are future tax gains.
- The fund strategy and whether that strategy would support recognition of tax losses, based on what needs to occur to use the tax losses, e.g. if a fund plans to divest from a particular jurisdiction, losses in that jurisdiction may become worthless, as tax losses can typically only be used to reduce income or gains within the same jurisdiction; conversely a fund which plans to expand investment in a jurisdiction would expect to have more scope to use brought forward losses in that jurisdiction.
- The fund investment growth projections and whether these support in whole or in part the recognition of tax losses, e.g. to paraphrase Jane Austen2, ‘it is a truth universally acknowledged that a fund will only invest in a market in expectation of gain’. On first principles there must therefore be an expectation of future gains within the fund. However further more detailed considerations may be required to justify recognition of tax losses, i.e.,
- will the gain be the ‘right’ type of gain, i.e. the type of income or gain against which the losses brought forward could be used?
- will the gain arise in the ‘right’ jurisdiction, i.e. in the jurisdiction which has losses brought forward?
- will the gain arise within the ‘right’ timeframe to enable the tax losses to be used, if those losses have a limited life?
- what is the expected quantum of that gain, i.e. will it be sufficient to recognise all of the brought forward losses or only some?
- Where there is more than one way in which tax losses can be used then the recognition and valuation of tax losses should reflect the most likely way in which the losses will be used, e.g. under Indian tax law, short-term tax losses can be used against short-term gains or against long-term gains but long-term losses can only be offset against long-term gains.
- The statutory accounting requirements regarding the disclosure and recognition of losses with the precise requirements varying depending on the accounting standards used by the fund, e.g. IFRS, UK GAAP, US GAAP.
- The regulatory requirements regarding the recognition of losses within the fund price, whether these are specific mandated requirements or a more general requirement to Treat Customers Fairly (TCF) e.g. consideration should be given to the appropriateness of aligning the recognition of losses in pricing with the statutory accounting requirements. Funds which report under IFRS for example, may wish to consider whether the IFRS prohibition on discounting tax losses is appropriate for pricing purposes.
Information on the capital losses within funds is essential to enable funds to make timely decisions on the recognition of losses. This information will be particularly relevant for fund managers both in the current COVID-19 environment and as markets rebound, as it will provide the management information required to appropriately assess the real world post-tax pricing impacts of rising markets, helping funds demonstrate that they are meeting their TCF requirements.
Tax rarely exists in a vacuum, rather with very limited exceptions tax is a consequence of wider financial markets and transactions. The Tax Accounting Policy must therefore ensure that the recognition and valuation of tax losses is made in the context of, and consistent with the environment within which the fund is operating, the fund’s overall strategy, and growth projections and the regulatory and accounting framework within which the fund operates thus helping to ensure that customers are treated fairly in the context of recognition and valuation of tax losses. Such matters are particularly relevant in a market shock situation, and in the immediate aftermath when markets rebound, times when audit and regulatory focus on tax loss recognition is likely to be particularly high.
2 Jane Austen, Pride and Prejudice