Tax calculations are turned around in a short timeframe, and therefore involve greater risk of human error and control failures. Such risks are compounded when complicated tax rules are applied to multi-billion dollar investment portfolios, and those risks are even greater when large organizations maintain manual offline internal processes.
How often have you heard your tax team refer to their inventory of deferred balances? Does that inventory number in the dozens, hundreds, thousands or tens of thousands? How often have you thought about what your tax team needs to accurately and reliably manage that inventory? Would you be more comfortable with that inventory of deferred balances managed by a manual or an automated solution?
The more diverse the activities of an organization, the greater the risks will be. Consider an example of a permanent difference such as tax-exempt interest income. Since tax-exempt interest income does not reverse in the future, it does not create a deferred tax asset. By its terms, this issue generally arises when an insurer invests in state or municipal bonds. So an insurer whose investment and risk profile does not include such activity has naturally mitigated their risk.
A temporary difference may arise where an insurer invests in securities purchased at a discount to par and where they defer any market discount accretion for tax purposes. Book value for US GAAP includes market discount accretion whereas tax basis for federal tax purposes remains as the original cost. Since this book-to-tax difference will reverse in the future (on sale or at maturity), it is considered a temporary difference so the anticipated future tax expense of this difference is part of today’s deferred income tax expense calculation.
This issue is more complicated where the market discount is separate and in addition to any original issue discount (OID). The two have to be calculated and tracked separately. It can get tricky when the OID should—but does not—accrete due to it being de minimis, or where that security issued with OID is purchased in the secondary market either at a premium to its adjusted issue price but below par or at a premium to par. The good news is that it is possible to manage these permutations automatically with an automated software solution that properly tracks the associated tax attributions and elections for such investments, rather than handling them manually offline.
Transfers are another activity that may generate book-to-tax differences. Insurers regularly transfer assets intercompany for a variety of reasons. Those transfers are often processed at book value for GAAP or STAT purposes but at market value for tax purposes. Any gains or losses on those intercompany market value tax transfers can then be deferred until the asset is sold to a third party (or transferred outside the group). Whether someone transfers 50, 500, or 5,000 (or more) assets, efficiently managing and tracking the movement of assets is vital for insurers. Knowing when any deferred gain or loss has been triggered via third-party sale then becomes key. A system that can properly handle the automated transfer of assets—and the monitoring of subsequent third-party sales—helps streamline this process by providing a systematic and error-reducing way to record and report this activity. Such automation ensures that assets are correctly tracked and categorized for tax purposes and that the respective transactions are accurately documented.
Automation not only saves time but also minimizes the risk of errors that could result in costly tax discrepancies. It allows insurers to maintain a clear audit trail, facilitating transparency and compliance with tax regulations.
Accurate documentation and reporting are the backbone of tax accounting. Insurers must maintain detailed records of all financial transactions, income and expenses, while also ensuring that these records align with tax regulations. Automated systems can play a pivotal role in generating accurate and compliant financial reports for tax purposes. The previously mentioned intercompany transfers, whether they are of 50, 500 or 5,000 (or more) assets, create a compliance burden that must be tracked either manually or electronically. With year-end approaching, how comfortable are you that any deferred intercompany balances that are triggered by third-party sales will be picked up? More interestingly, if you were looking to intentionally trigger those balances, do you have an accurate and reliable inventory of those assets and deferred balances from which to identify which should be sold?
In an increasingly complex and time-constrained world, the automated solution will always provide greater flexibility and mitigate the most risks.
To fully optimize their tax accounting, insurers should consider integrating their accounting system with specialized tax compliance software. This integration ensures that financial data is seamlessly transferred to tax software, reducing manual data entry and the risk of errors.
Furthermore, tax compliance software can help insurers stay up-to-date with changing tax regulations, calculate tax liabilities accurately and generate the necessary tax filings and reports.
Written by John Pavlakis
Vice President, Global Institutional Tax