Questions are being raised about how the accounting profession will respond to the introduction of a new accounting rule, FIN 48, when it applies to asset managers.

Several issues look likely to impact the accounting and auditing profession in Cayman. The biggest worry, according to Noel Reilly at PricewaterhouseCoopers, is the European Union’s alternative investment fund managers (AIFM) directive and the impact it could have on offshore fund products.

The rules as they now stand have the potential to restrict the distribution of offshore products within the EU. This is a particular problem for US hedge fund managers, particularly if they are unable to distribute and market their funds to investors inside the EU. Although US Treasury Secretary Tim Geithner has strongly urged the EU to reconsider what many see as a protectionist stance, the outcome of his intervention and the union’s deliberations are unknown.

Another EU initiative that is exercising minds in Cayman is the directive on auditing. Offshore auditors are also subject to the rules which are similar to those imposed by the US Securities and Exchange Commission.

Under this directive auditors need to demonstrate they are subject to an “acceptable” inspection programme. The need for an oversight body to show auditors and accountants are regulated properly is a role the Cayman Islands Monetary Authority (CIMA) is likely to outsource. At present there are two options. One is to use the appropriate authority in the UK (something the Channel Islands are doing). The other is to use a Canadian institute that has offered to perform this duty. CIMA has yet to make public its decision on this but few are worried about its ability to find a solution to make Cayman-based auditors and accountants compliant with the directive.

Like others in the industry, Reilly is concerned with Cayman’s position as the number one domicile for hedge funds. While numbers in 2009 were only down around 3%, Reilly thinks it could be a couple more years before the true number of de-registrations will be seen as some funds are in a gradual wind-down following the financial crisis. He is not certain the number of new fund registrations will be enough to make up the difference and also show growth.

“We are entering an era of new start ups but the numbers may not be enough to balance the de-registrations by funds that are closing or winding down,” notes Reilly. With continued uncertainty over regulation of funds as well as tax positions, he believes there is potential for a negative impact on Cayman.

A more pressing logistical issue that could seriously affect the accounting and auditing progression are plans being contemplated by CIMA to cut the deadline for presentation of audited reports on funds to only three months from the existing six. Reilly believes such a move could have a negative impact on auditing companies, significantly driving up costs as extra  staff would be needed to cope with the high number of audits due in the first quarter of the year. At present the six month deadline for single funds and an even longer one for funds of hedge funds means the auditing work is spread over at least nine months of the year. How the profession would cope with a change in the rules in Cayman – something the Securities and Exchange Commission in the US is also considering – remains to be seen. Reilly is unsure how the audit industry could structure itself in order to cope with increased demand for services in only a small part of the yearly work cycle.

Another major challenge for the auditors of asset managers is the introduction of what is known as FIN 48. Companies that issue US GAAP (generally accepted accounting principles) audit reports will need to comply with the Financial Accounting Standards Board (FASB) FIN 48 provision, starting with the accounting year ending December 31, 2009.

FIN 48 is attracting a lot of attention among asset managers, as alternative investment funds that use US GAAP must now formally document and assess their inventories of “uncertain tax positions” for the 2009 financial year.

The adoption process has presented asset managers, particularly those with a more international trading presence, with a unique set of challenges. A common feature of many fund structures, particularly master funds, is their flow through status for US federal tax purposes. This leads to investor-level issues outside FIN 48. If the uncertain tax positions were to crystallise, they would become direct tax liabilities of the fund.

For example, does the fund have a taxable presence (a permanent establishment) in any of the locations in which it has investments or where its management functions are carried out? The governing law as it applies to funds is often either unclear. Where there is no taxing authority precedent with respect to calculation of capital gains tax on trading, the position is unclear. For example, the imposition of non-resident capital gains tax on profits made from equities and other trading positions could be liable to tax. So, a technical exposure could still exist for the fund.

If a tax position fails the ‘more-likely-than-not test’, the corresponding tax benefit is not recognised in the company’s financial statements. For positions that meet the test, FIN 48 outlines a complex process for determining the portion of the benefit that should be recognised. In either case, the company must establish reserves for the portion of the tax benefit that is not recognised and make financial statement disclosures about uncertain tax positions. “FIN 48 has moved the goal posts in terms of recognition,” says Reilly. Funds will no longer be able to look just at administrative practice and assume the tax authority where trades take place will not start charging capital gains tax.

Reilly says the situation is not quite as difficult as at first glance. The number of countries that have not clarified their tax policy are few. However, some of them are significant. Two in particular are cause for some concern. Both Australia and Spain have not yet made clear their policy on the profits made from trades on their stock exchanges. For funds that do a lot of trading through Australia, this could prove a difficulty.

“The question is if there will be a recognised tax liability in relation to some of these trades,” notes Reilly. If the likelihood was the fund would never need to pay capital gains, there is little problem However, if there is a possibility that the fund could be liable for taxation, this needs to be reflected in the accounts and money set aside to pay for the possible tax liabilities. This could impact subscriptions, redemptions and net asset value (NAV) calculations, warns Reilly. All three could be distorted if a fund needs to account for possible tax liabilities that may never materialise.

Auditors are still discussing just how they should deal with FIN 48’s impact. Reilly says that generally funds are diversified across a number of countries and are less likely to see any material tax impact. Nevertheless, for those where trading is high in countries which have an unclear tax position, the costs could be great.

According to Reilly in theory under FIN 48 a fund that has been trading for the past five or more years would need to set aside funds in case they needed to pay capital gains tax in that country.

This is where the problems begin. Such set-asides could affect not just the calculation of the NAV but the amount at which investors enter or exit a fund. How funds – and auditors – deal with this is going to be exercising minds in 2010, Reilly predicts.

Looking at Cayman, Reilly is confident like others in the industry that Cayman will do what it has to in order to stay at the forefront of an evolving industry. Whatever challenges are put in front of Cayman – accounting regulations or potentially damaging onshore regulation – he believes Cayman will be able to survive and prosper.