Income Tax (ASC 740) Considerations for Investment Companies

Today’s post combines two of my all-time favorite topics, accounting for income taxes under ASC 740 and investment companies (ASC 946). You might already be wondering, wait a minute, aren’t investment companies, or funds, exempt from taxation? Don’t they effectively operate as pass-through entities, passing the tax burden on to the investor in the fund? The answer is generally yes, but that doesn’t excuse them from considering certain parts of the accounting guidance for income taxes. This post explores the income tax considerations for investment companies.

Example: Income tax considerations for investment companies

Let’s take a look at an example to illustrate the point of the post:

Incognito Ltd. is an investment company domiciled in Caymuda, a small island nation with certain tax advantages for companies and wealthy investors on the mainland. Incognito is a subsidiary of Wall Street Financial Corp., a diverse financial services provider. Thurston Howell, CFO of Wall Street, sends a request to Incognito for supporting documentation of its 2021 assessment for uncertainty in income tax positions. Skipper Gilligan, the administrator, investment manager, transfer agent (and janitor as he is the only employee at Incognito), replies to Mr. Howell with a one-line email, “Incognito Ltd. is a tax-exempt entity and therefore does not have any current (or deferred) tax obligations, and ASC 740 is therefore not relevant to our entity.” Upon receiving the email from Mr. Gilligan, Mr. Howell provides this documentation to the auditors.

Assume that you are the auditor of Wall Street Financial. Do you have any concerns with the entity’s (and its subsidiary’s) compliance with the guidance on accounting for income taxes under ASC 740? You can assume that Incognito meets the definition of an investment company under ASC 946.

Debrief: Income tax considerations for investment companies

The answer is that Incognito is not exempt from all the guidance related to income taxes under ASC Topic 740. If it truly qualifies as a tax-exempt entity under the relevant tax code, then it won’t have any tax obligations. However, qualifying as a tax-exempt entity isn’t always easy and there are lots of rules about qualifying for, and then maintaining, a tax-exempt status. That is certainly true in the United States for all kinds of tax-exempt, or pass-through entities, such as LLCs, LLPs, LPs, S-Corporations, etc., and we will assume the same is true in Caymuda. This brings us to the issue of uncertain tax positions.

Uncertain tax positions

Asserting that an entity qualifies for tax-exempt status is a tax position, which is defined in ASC 740 as:

A position in a previously filed tax return or a position expected to be taken in a future tax return that is reflected in measuring current or deferred income tax assets and liabilities for interim or annual periods. A tax position can result in a permanent reduction of income taxes payable, a deferral of income taxes otherwise currently payable to future years, or a change in the expected realizability of deferred tax assets. The term tax position also encompasses, but is not limited to:

• A decision not to file a tax return
• An allocation or a shift of income between jurisdictions
• The characterization of income or a decision to exclude reporting taxable income in a tax return
• A decision to classify a transaction, entity, or other position in a tax return as tax exempt
• An entity’s status, including its status as a pass-through entity or a tax-exempt not-for-profit entity

Tax positions, and the uncertainty around them, must be evaluated using a more-likely-than-not threshold under ASC 740. This guidance focuses on how transactions will be treated under the tax law and whether positions taken on tax returns should be reflected in financial statements. It applies to all tax positions accounted for under ASC 740, therefore, Incognito’s claim that it qualifies as “tax-exempt” must be evaluated.

Special considerations for mutual funds

In the United States, the consideration of uncertainty in income taxes might be even greater for a mutual fund. Mutual funds are commonly organized as a type of corporation, and corporations are taxable entities under the Internal Revenue Code (IRC). However, there is a special election available under Subchapter M of the IRC that allows a corporation that meets the definition of an investment company to elect to be treated as a “Regulated Investment Company (RIC)”.

Unlike a regular corporation, RICs can deduct dividends distributed to shareholders. If a RIC distributes all its earnings via dividends, then it can effectively have zero tax liability. However, in addition to the need to distribute all its income, there are certain tests related to asset diversification, gross income, and distributions that the entity must meet to maintain its status as a RIC. So, the moral of the story here is that the guidance for uncertainty over income tax positions definitely applies.

Final thoughts

If at any point an investment company loses its tax-exempt status, or in the case of a mutual fund, its RIC status, then the full guidance for accounting for income taxes in accordance with ASC 740 applies.

Interested in learning more about the accounting for income taxes under ASC 740, including uncertainty in income taxes? Check out our online course collection ASC 740: Accounting for Income Taxes. Need a refresher of the industry-specific accounting issues involving investment companies? Well, look no further than our top-selling Investment Management Industry Fundamentals course collection!

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Disclaimer
This post is for informational purposes only and should not be relied upon as official accounting guidance. While we’ve ensured accuracy as of the publishing date, standards evolve. Please consult a professional for specific advice.