Rethinking the Approach to Corporate Tax Reserves

Tax reserves for uncertain tax positions maintained by US companies are substantial. Over 25 Fortune 100 companies disclose such tax reserves with values exceeding $100 million. Uncertain tax positions can have a negative effect on earnings. Companies must reserve funds when the auditor is unable to get comfortable with a tax position, and this liability on the balance sheet drags earnings down. The earnings drag will continue until the IRS review period expires, during which time the company is exposed to the real possibility of an adverse view by the tax authority that can deplete the reserve for good.

Tax insurance has traditionally protected companies against the failure of a transaction or tax planning to qualify for its intended tax treatment, resulting in an unanticipated or ill-timed cash tax loss. It is a proven, efficient and cost-effective tool to bring certainty to the treatment of a US, state, local or foreign tax position. But there is a broader positive application that can be accretive to a company’s earnings, due to favorable accounting treatment under US GAAP. Interestingly, today’s tax insurance capacity per risk exceeds the average tax reserve posted by Fortune 100 companies.

A Big Four accounting firm has provided Aon with guidance on the proper accounting treatment of tax insurance and its impact on the financial statements. They confirmed that tax insurance can, indeed, impact FIN 48 reserves positively and similarly affect corporate earnings and balance sheets where uncertain tax positions have been recognized. By purchasing tax insurance, companies can transfer the full or partial risk from the tax exposure to the tax insurers, releasing a liability and a corresponding full or partial credit to income. This potentially results in higher earnings, a lower effective tax rate, and higher share price.

Tax insurance has grown and evolved into a major risk management tool. Today, with the maturation of the market, tax risks unrelated to an M&A transaction are routinely covered. CFOs, controllers and corporate tax professionals now have a tool at their disposal that can not only manage risk, but can be strategically leveraged to have a positive impact on their company’s earnings.

It is important to be aware that tax insurance is not a vehicle to avoid reporting and disclosure requirements under US GAAP applicable to aggressive tax positions, and many positions for which reserves are maintained are not insurable. However, for uncertain positions where companies have conservatively posted a tax reserve, notwithstanding positive tax advice of counsel, accountants or other advisors, tax insurance may offer a means to avoid or reverse the income statement hit associated with recognition of the uncertain tax position. Companies should consult with their own tax advisors and Aon for advice with respect to a specific transaction or situation, and its insurability.

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Disclaimer: Companies should consult with their tax advisors with respect to the proper tax treatment of a specific transaction or situation, and with its auditors regarding accounting treatment.

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