On September 29, 2010, the U.S. House of Representatives passed the Regulated Investment Company Modernization Act of 2010 (H.R. 4337), a bill designed to update the tax laws governing mutual funds. The bipartisan bill has moved to the Senate where it is expected to pass without opposition, and may be voted on during the lame-duck session after the November elections. The legislation represents the most comprehensive reform of mutual fund tax laws in nearly 25 years. The following are some of the key provisions, and what they may mean for you and your clients.
Provision: Unlimited carryforwards of net capital losses
Under current law, a mutual fund may carry forward a net capital loss from any year as a short-term capital loss to offset its capital gains, if any, realized during the eight years following the year of the loss. However, if a mutual fund’s capital loss carryforwards exceed its capital gains during this eight-year period, the gains must be distributed to shareholders, even though the fund may still have a cumulative net loss. The new law permits a fund to carry a capital loss forward indefinitely under rules similar to those that apply to individuals, including the retention of its character as either short term or long term. This change applies to net capital losses for taxable years beginning after the date the bill is enacted into law.
What it means for you and your clients
If a fund has generated more capital losses than capital gains on its portfolio transactions, it will not be required to make a capital gain distribution to shareholders. Investors holding shares in a taxable account will avoid having a tax liability from a fund that has a cumulative net loss.
Provision: Ability to invest directly in commodities and commodity-index derivatives (e.g., swaps and futures)
Under current law, the tax code requires mutual funds to pass a qualified income test by which they must obtain at least 90% of their income from so-called “good income,” such as dividends, interest, and gains from sales of securities. Income from commodities does not qualify as good income, and a fund may not derive more than 10% of its gross income from direct investments in commodities. The bill would allow mutual funds to include income from direct commodities investments in their good income.
What it means for you and your clients
Mutual funds are currently able to invest indirectly in commodities via structured notes or through a wholly owned subsidiary. However, these vehicles entail legal costs, potential credit risks, and substantial fees. Under the new law, funds would be able to invest in commodities and derivatives on commodities more cost effectively, which may allow firms to reduce expense ratios on certain funds. It may also enable multi-asset class funds to increase their investments in commodities, which could improve diversification and risk-adjusted performance.
Provision: Qualifying upper-tier funds in a fund-of-funds structure will be permitted to pass through tax-exempt interest and foreign tax credits without regard to the 50%-of-assets rule.
Existing law allows mutual funds to pass through tax-exempt interest and foreign tax credits if more than 50% of the fund’s assets are composed of municipal bonds or equities issued by foreign corporations. In a fund-of-funds, the top-tier fund is limited in its ability to separately pass these tax attributes to its shareholders because it does not technically meet this 50% requirement. The bill removes this requirement for top-tier funds.
What it means for you and your clients
Investors holding funds-of-funds in taxable accounts will receive the same benefits from tax-exempt interest and foreign tax credits as those investing in individual funds.
Provision: Modification of allocation rules for capital gain distributions
Under current law, funds must send shareholders IRS Form 1099 based on dividends and distributions paid during the calendar year, even though the character of those dividends and distributions cannot be determined until the fund’s fiscal year closes. This can and does lead to errors in Form 1099 reporting, requiring funds to send amended year-end tax information to shareholders, which in turn, frequently requires shareholders to file amended tax returns.
What it means for you and your clients
For funds with a fiscal year overlapping two calendar years that report excess capital gains, the bill will permit the fund to reduce its capital gain distributions in the subsequent calendar year by the amount of excess distributions reported in the prior year. This increased reporting flexibility should help minimize the number of situations in which investors will need to file amended tax returns.
Provision: Simplified cost-basis reporting for tax-exempt bond fund investors
Under current law, if a shareholder sells mutual fund shares held for six months or less after receiving tax-exempt dividends on those shares, any capital loss is disallowed to the extent of the dividends received. In the new bill, capital losses on short-term sales will be permitted regardless of tax-exempt dividends received as long as the mutual fund’s tax-exempt dividends equal at least 90% of its net tax-exempt interest and the fund distributes its dividends on at least a monthly basis.
In an additional provision related to municipal bond funds, current law prohibits tax-exempt funds from reducing their current earnings by deducting interest expense and amortizable bond premiums. If a fund over distributes its income, this rule effectively converts what would otherwise be a return of capital into an ordinary (taxable) dividend. The Act fixes this problem by allowing muni-bond funds to apply these previously disallowed deductions when calculating earnings and profits.
What it means for you and your clients
Shareholders in most tax-exempt bond funds will be able to realize losses on short-term sales irrespective of whether they received tax-exempt dividends on the shares sold.
Under the second provision, if a municipal bond fund distributes what is, economically, a return of capital, fund shareholders will be able to recognize it as a return of capital.
More to come
Putnam strongly supports the much-needed tax reforms in the Investment Company Modernization Act, and we believe the bill will soon be passed in the Senate and signed into law. We will continue to monitor the situation closely and will keep you up to date on developments as they unfold.
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