Young Scholars Charter School serves sixth, seventh, and eighth grade students from North Philadelphia and is the highest performing charter middle school in the City of Philadelphia.  The school uses a focused, progressive educational approach designed to close the achievement gap for its more than 200 low-income, minority students, who arrive at the school from District schools severely under-prepared. Students spend 33 percent more time in the classroom than their peers in District schools.  Despite entering Young Scholars at least one level below grade level in math and/or reading, the school’s eighth graders surpass their District peers in math and reading and are at or near the state average. 98 percent of the school’s graduates go on to a college preparatory high school.

In late 2009, BBD’s Service Committee recommended that the firm begin a partnership with Young Scholars Charter School.  The committee, and the firm’s partners, recognized that as a local business, BBD has a responsibility to invest in Philadelphia’s future business leaders and workforce.  Helping to close Philadelphia’s achievement gap is key to investing in the city’s future.

 The partnership officially began with a sponsorship of computer-related education for Young Scholars students and their families.  The partnership continued throughout 2010 with both financial commitments and events designed to connect Young Scholars students with BBD firm members.

 “In each of our endeavors with Young Scholars, whether we were helping to support the art auction, hosting students at our office, or participating in a joint effort with the students to help out in one of the city’s soup kitchens, we came away more impressed than the time before with the character of the students and the citizens the school is developing,” said Mike Boyle.

 BBD’s partnership with Young Scholars Charter School is expected to continue throughout the summer and into the 2010-2011 school year.

As I am starting to work with more and more Exchange Traded Funds (ETFs), it is becoming increasingly apparent that they need their own specific set of accounting and reporting rules.  Currently, an ETF falls under the guise of an open end management investment company registered under the Investment Company Act of 1940.  While this classification is technically correct, there are certain rules / guidance for open end 40 Act investment companies that really do not make sense for an ETF.  One example is the method by which total return is required to be calculated.  Another, while admittedly more debatable, is the use of fair value adjustment factors when valuing investments domiciled on foreign exchanges for the purposes of determining the daily net asset value (NAV) of the ETF.

First, it may be worthwhile to explain, in very general terms, the difference between an open end mutual fund, a closed end mutual fund, and an ETF.  An open end mutual fund is an investment company that sells and repurchases shares at its net asset value directly to and from the investor.  There is no secondary market for an open end fund as the fund acts as the buyer or seller in each transaction.  On the other hand, a closed end mutual fund is an investment company whose shares trade much like the shares of a common stock.  The fund may issue shares at net asset value via a public offering and repurchase shares via a stock re-purchase plan.  However, shares of closed end funds are primarily purchased and sold in the secondary market at the market price, which may be more or less (premium or discount) than the fund’s net asset value.  An ETF is kind of hybrid of an open and closed end fund.  An ETF can issue and redeem shares at net asset value to qualified participants in exchange for a basket of securities that correspond with the index that the ETF is designed to track.  This issuance of shares is commonly referred to as  creation units, which are normally issued in lots of 50,000 shares.  The qualified participant can then trade these shares in the secondary market.  Most investors do not qualify to obtain or redeem shares directly from an ETF and thus must purchase and sell the ETF shares in the secondary market at market price, which again may be more or less (premium / discount) than the net asset value of the fund.  If the shares of an ETF begin to trade at a significant discount, a qualified participant is able to purchase a block of shares in the secondary market at the discount and then redeem them at net asset value from the fund and benefit from the arbitrage in price.  If the shares are trading at a significant premium, qualified participants have incentive to create more shares and sell them in the secondary market at a premium, again profiting from the arbitrage in price.  This ability of qualified participants to profit from arbitrage in price effectively keeps the discount/premium of most ETFs in a reasonable range.  So, as you can see, an ETF has characteristics of both a closed end and open end mutual fund.

The SEC, in the instructions to Form N-1A, provides the mechanics on how to calculate total return for an open end investment company.  The instructions require the assumption that an investment is made at the NAV at the beginning of the period and redeemed at the NAV at the end of the period, with any distributions reinvested at the NAV on the ex-dividend date.  As an ETF files its registration statement on Form N-1A, total return is required to be computed based on this NAV formula.  This provides a total return that no investor could ever achieve.  Yes, qualified participants could purchase and redeem shares at NAV, but reinvestment of distributions is generally only available at the discretion of the broker and, if permitted by the broker, the shares are purchased in the open market at market price.   However, most investors would need to purchase and sell their shares and reinvest their distributions at market value. 

Closed end funds provide a total return assuming market value at the beginning end of the period with reinvestments of distributions made at the lower of the cost or market value.  Many ETFs also present a total return using this methodology in their financial highlights.  This calculation for an ETF would provide a return that comes close, and in some cases (if the market price on ex-date was lower than NAV) accurately reflects the return earned by investors who are not qualified participants.

It would make most sense to require ETFs to provide two total returns.  The first would assume the investment was made and redeemed at the NAV with any distributions reinvested at the market price.  This would accurately reflect the return earned by the qualified participants.  The second total return should be calculated assuming an investment was made, redeemed, and any distributions reinvested at market price.  This total return would accurately reflect the return earned by individual investors.

It is imperative for open end investment companies to value their investments at fair value when determining their net asset value (“NAV”).  For investment companies that invest a significant portion of their investments in foreign securities, the importance of fair value is magnified.  Due to different time zones, many foreign exchanges close well before the close of the US markets.  If significant events occur after the close of the foreign markets, but before the close of the US markets, the closing price of the foreign investments will not be reflective of the current market value.  This creates arbitrage opportunities for market timers.  Market timers look to profit from these arbitrage opportunities and do so at the expense of the remaining shareholders of the fund.  To combat market timers, most mutual funds that invest in foreign securities utilize fair value factors to adjust closing foreign prices to reflect events occurring after the close of the foreign markets but before the close of the US markets.  Some funds establish a  threshold or trigger of movement that must occur before applying the fair value factors, but more and more funds are beginning to apply fair value factors on a zero threshold basis.

The use of fair value factor is certainly an effective tool for combating market timing in a regular open end mutual fund, but does it make sense for an exchange traded fund (“ETF”)?  I think not, though some may consider such an opinion to be controversial.  My reasoning is quite simple.  Subscriptions and redemptions of ETF shares by qualified participants are made in-kind.  If a qualified participant attempts to profit from the inefficiencies in the pricing of the underlying securities of the fund by redeeming shares, the redemption will be paid to the participant in the form of the same inefficiently priced securities.  While non-qualified participant market timers will certainly invest in ETF shares and seek to profit through arbitrage opportunities, such arbitrage will not come at the expense of the remaining shareholders in the fund since it will be facilitated in a secondary market.  Further, it is not possible for a qualified participant to market time an ETF in such a manner that they would profit at the expense of the remaining shareholders of the ETF since as explained above, their redemption of shares will be made in-kind.

 Another argument against using fair value adjustments in an ETF is that such practice would create what is commonly referred to as “tracking error.”  The investment objective of an ETF is generally to mirror the return of a particular index.  The tracking error is the extent to which the return of the ETF does not match the return of the benchmark index.  All benchmarks use closing prices without fair value adjustment factors.  Therefore, the use of fair value factors in an ETF will cause tracking error and may reflect negatively on the management of the ETF.

The only debatable point with respect to fair value factors relates to the trading in the secondary market.  To some extent, the trading activity of an ETF may be related to its discount or premium from its NAV. But what are the investors’ expectations with respect to how the NAV of the ETF is determined?  If events occur after the close of the foreign market that negatively affect the securities in index, would investors in a corresponding ETF expect such an ETF to trade at a discount to NAV or would they expect the NAV to be reflective of the subsequent event?  I would think they would expect the pricing to match that of the index, but the answer is unclear and is the key to solving the ETF fair value dilemma.

215/575-6111
E-mail Melissa Dunn

Like all members of BBD’s Not-For-Profit Group, Melissa is dedicated full-time to serving the accounting, audit and tax needs of our more than 100 not-for-profit clients.

In addition to serving as an in-charge accountant for the audits of many of our not-for-profit organization clients, Melissa regularly provides training on such timely issues as the implementation of the new IRS Form 990.

Education

• Ursinus College- Bachelor of Arts in Business and Economics
• Phi Beta Kappa

Associations

• American Institute of Certified Public Accountants
• Pennsylvania Institute of Certified Public Accountants

Community Involvement

• Founding member of BBD’s Service Committee, which plans and executes BBD’s community activities
• Treasurer of A Drink For Tomorrow, a New Jersey-based not-for-profit organization dedicated to fundraising for clean, safe drinking water for at-risk populations around the world

Like all members of BBD’s Not-For-Profit Group, Mike is dedicated full-time to serving the accounting, audit and tax needs of our more than 100 area not-for-profit clients.

Mike serves as an in-charge accountant for the audits of many of our not-for-profit clients.  His extensive experience with the unique business challenges facing the not-for-profit community as well as his personal dedication to our clients add significant value to the services we provide.

Education

• Widener University- Bachelor of Science with a major in accounting

Individual tax provisions

Important tax provisions affecting individuals include:

Penalties for the uninsured. Beginning in 2014, most individuals who aren’t eligible for Medicaid, Medicare or other government-provided coverage will be required to purchase minimum essential health coverage. Those who fail to do so will be hit with a penalty (with exceptions for the poor and certain others).

Premium assistance for those with lower incomes. Beginning in 2014, people with income between 133% and 400% of the federal poverty level (FPL) are eligible for tax credits or cost-sharing subsidies on a sliding scale to help pay insurance premiums.

Higher taxes on the affluent. To help offset the act’s cost, affluent taxpayers will face higher taxes. Beginning in 2013, taxpayers with more than $200,000 in earned income ($250,000 for families) will pay an additional 0.9% Medicare tax on the excess. In addition, those with an adjusted gross income (AGI) over $200,000 ($250,000 for joint filers) will pay a new, 3.8% Medicare tax on unearned income, such as interest, dividends, rents, royalties and certain capital gains. The tax doesn’t apply to retirement plan distributions.

Also starting in 2013, the act raises the threshold for deducting unreimbursed medical expenses from 7.5% to 10% of AGI and limits contributions to flexible spending accounts for medical expenses.

Business tax provisions

Key tax provisions affecting businesses include:

Penalties for failure to provide coverage. The Patient Protection act doesn’t require employers to provide insurance coverage, but starting in 2014 it imposes tax penalties on certain employers that don’t provide it. Employers with 50 or more full-time-equivalent workers (FTEs) that don’t offer coverage and have at least one full-time employee who receives a premium tax credit are subject to an annual fee of $2,000 per FTE (not including the first 30 FTEs).

Tax credits for small businesses. Starting this year, small businesses are entitled to tax credits for purchasing group health coverage. For tax years 2010 to 2013, the maximum credit is 35%, provided the employer contributes at least 50% of the total premium or 50% of a benchmark premium. Starting in 2014, a maximum credit of 50% is available for two years for employers that purchase coverage through a state exchange and contribute at least 50% of the total premium. Smaller credits are available for tax-exempt businesses.

Excise tax on “Cadillac” plans. Starting in 2018, high-cost group plans will be subject to a 40% nonrefundable excise tax. The tax applies to annual premiums in excess of $10,200 for individual coverage and $27,500 for family coverage (excluding stand-alone dental and vision plans). The thresholds are higher ($11,850 and $30,950, respectively) for retirees and employees in certain high-risk professions. These amounts will be indexed for inflation.

An all-encompassing act
The tax provisions of the Patient Protection act will have an impact on most taxpayers, as well as on how employers deal with health care insurance for their employees. Please contact us if you have questions about how the provisions may affect you or your business.

Click here to view new guidance from the IRS on the Small Business Health Care Tax Credit.

Payroll tax forgiveness
This essentially exempts qualified employers (generally employers other than government entities) from having to pay the 6.2% Social Security portion of Federal Insurance Contribution Act (FICA) taxes on certain new hires through the end of the year. To qualify, a worker must be hired after Feb. 3, 2010, and before Jan. 1, 2011, and must have been unemployed (defined as not having worked more than 40 hours) for the 60-day period ending on his or her start date.

Retention credit
This credit applies to workers who qualify for payroll tax forgiveness if they are retained for 52 consecutive weeks. The tax savings per qualified retained worker are equal to the lesser of 6.2% of the wages paid to the worker in 2010 or $1,000.
 
Sec. 179 expensing
The HIRE act extends the increase in the Section 179 limit for initial year expensing to $250,000 (from $134,000). The Sec. 179 expensing election allows a current deduction for newly acquired assets that otherwise would have to be depreciated over a number of years. The HIRE act also extends the increase in the threshold at which the expensing election begins to phase out to $800,000 (up from $530,000). The higher limits apply for calendar year 2010 or a business’s fiscal year that begins in 2010. A business can claim the expensing election only to offset its net income, not to reduce net income below zero.

Other provisions
The HIRE act includes additional provisions that may be of interest to you, such as:

• A new election to convert tax credit bonds to Build America Bonds
• Extension of highway and transit programs through 2010
• Strengthening of foreign account tax compliance
• Deferral of implementation of “worldwide allocation of interest” to 2020

Various changes to estimated tax payment requirements for certain large corporations also were included in the act, but they don’t go into effect until 2014 or later.

Many rules apply
These breaks might provide your business with valuable tax savings, but many rules apply to them. So please contact us for the details before acting.

Click here to view questions and answers for employers about the HIRE Act, provided by the IRS.

Is a Time Deposit a security or a cash item?  The answer is both.  There are very few short-term instruments that are treated as a cash item under the 40 Act.  The SEC has long considered time deposits and other money market instruments to be securities.  Therefore, for the purposes of financial statement presentation, time deposits are indeed securities.

Not surprisingly however, the IRS guidance available on this subject is inconsistent with the SEC.  There are General Counsel Memorandums and Treasury Regulations that clearly include Time Deposits in the definition of a cash item.  Therefore, for the purposes of the asset diversification test, one could reasonably treat Time Deposits as a cash item.  Therefore, a Time Deposit is both a cash item and a security, depending on the purpose of the classification.

I recently received a question regarding a Fund that invests in India through the purchase of Participatory Notes (“P-Notes”).  The question was whether or not P-Notes should be classified as derivatives for the purposes of the financial statements and related disclosures.  On the surface, this seems like a simple question.  A P-Note is a note issued by a broker registered with the Stock Exchange Board of India (“SEBI”).  The issuer of the note purchases the underlying security and passes the income/loss generated by the security to the note-holder.  SEBI does not allow investors to invest directly in Indian securities unless such investors are registered as Foreign Institutional Investors (FIIs).  P-Notes allow investors to gain exposure to Indian securities without registering with SEBI. 

Since a P-Note derives its value from an underlying security, one might conclude that a P-Note is a derivative.  In financial terms, I would agree with such a conclusion.  However, it would be too easy for the Financial Accounting Standards Board (FASB) and the financial world to have the same definition of a derivative.   Per FASB, deriving value from another security will not automatically render an instrument a derivative.  One characteristic that an instrument must have to be considered a derivative per FASB is that the instrument would require no initial investment or an initial investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.  This characteristic is not met with a P-Note.  There is also a net settlement requirement in the FASB definition.  Once an investor purchases a P-Note, the investor has no further obligation.  Thus, the concept of a net settlement would not seem to apply.  Therefore, my conclusion is that a P-Note, while certainly a derivative in financial terms, is not considered a derivative for financial statement purposes.  While it may look and feel like a derivative, it is more akin to an ADR.

One of my colleagues once said to me, “Why won’t the IRS just let regulated investment companies just invest in commodities?”  Many funds seek the commodity exposure, and many are finding creative ways to circumvent this restriction.  I recently worked with a client who is creating a Controlled Foreign Corporation (“CFC”) as a means to gain commodity exposure in their mutual fund.  This concept has been blessed by the IRS via a Private Letter Ruling. 

How does this work? 
A CFC is a foreign (probably Cayman) corporation that invests in commodities and futures contracts on commodities.  It is wholly-owned by a U.S. regulated investment company.  The U.S. investment company invests up to 25% of its assets in the CFC.  Income earned from the CFC is deemed to be a dividend to the mutual fund, which is treated as qualifying income for the purposes of the 90% gross income test.  If a mutual fund invests directly in commodities or futures contracts on commodities, the income earned from such investments will not be treated as qualifying income.  Therefore, the CFC magically cleanses the income from the commodities and converts it to qualifying income.   

What are the operational issues? 
The biggest issue with this setup is that the GAAP and tax treatments are contradictory.  For GAAP purposes, the CFC must be consolidated with the mutual fund, as the fund has a controlling interest – 100% in this scenario.  There is a rather large fund complex with a fund that has this arrangement that did not consolidate.  While I do not know all of the details, that would seem to be incorrect to me.  For U.S. Income tax purposes, the CFC is treated as a separate entity. 

It is expected that there will be numerous purchases and sales of the CFC during the year as the fund’s advisor will attempt to manage the fund’s exposure to commodities, and the fund’s assets will fluctuate during the year due to market fluctuation and subscriptions and redemptions in the fund.  These will generate gains and losses on the books of the fund.  These gains and losses will need to be eliminated in the consolidation of the CFC when preparing the financial statements.

For tax purposes, any income earned by the CFC will be treated as a deemed distribution of income to the fund and increase the funds basis in the CFC.  Losses incurred by the CFC, determined on an annual basis, do not flow through to the fund and are deferred until the fund’s position in the CFC is eliminated.  Any sales of the CFC will first be treated as a redemption of the earnings and profits of the CFC.  Any redemptions in excess of the earnings and profits of the CFC will be treated as a return of capital.  Therefore, there are no capital gains/losses to be realized from the investment in the CFC. 

Another operational issue relates to the IRS diversification requirements that prohibit a single fund investment from exceeding 25% of its gross assets.  There is an exception which allows an investment to exceed 25% of the gross assets if the excess is solely due to market appreciation – i.e. the investment was less than 25% of the gross assets immediately after the most recent purchase.  However, as mentioned above, any income earned from the CFC is deemed to have been distributed and increases the fund’s basis in the CFC.  Is this essentially a purchase of the CFC?  Does this eliminate the market appreciation exception?  I would say no, as the CFC income is determined annually, but one cannot be certain how the IRS would interpret this.  However, since the fund will likely be making routine purchases of the CFC, the magnitude of the market appreciation exception at a minimum will be greatly reduced.  Therefore, if the investment in the CFC exceeds 25% of the gross assets at any quarter end, I would recommend taking the conservative approach and invoke the cure provision by reducing the position to less than 25% within the requisite 30 days after quarter end.

 The last operational issue I uncovered relates to the required distributions necessary to avoid excise tax, especially for a fund that is not a calendar year-end company.  Specifically, how do you determine the amount of income earned from the CFC for the purpose of computing the amount of income to be distributed?  The easy answer is the sales proceeds up to the amount of the earnings and profits of the CFC.  However, the earnings and profits of the CFC cannot be determined until the end of its fiscal year. For sake of ease of consolidation, most will likely be inclined to have the CFC adopt the same fiscal year-end as the fund.   If you are not familiar with the excise tax rules, a fund must distribute by December 31^st of each year 98% of its capital gains earned during a 12 month period ending October 31 and 98% of its income earned during the calendar year.  Therefore, the amount of income earned from a non-calendar year-end CFC is not determinable in time to make the required excise distribution.  This creates two choices for the fund: 1) treat all proceeds as being from earnings and profits of the CFC and subject to distribution; 2) disregard the CFC income for the purposes of excise distribution.  While the first option would avoid any excise tax, it does create the potential for a 1099 error, and the penalty for incorrect 1099s can be quite severe.  While the second option will likely create excise tax equal to 4% of the shortfall of the amount distributed from what was required to be distributed, it will avoid any potential 1099 penalties.  Neither scenario seems ideal.  For these reasons, it is imperative that the CFC choose a calendar year-end, regardless of the year-end of the parent fund.  Unfortunately, this will complicate the consolidation of the fund and the CFC for financial statement purposes.

Pros and Cons
The pros are pretty simple.  Utilizing a CFC is a way to gain commodity exposure in a mutual fund without causing the fund to fail the 90% gross income test and subsequently lose RIC status.  There are a few cons however.  The most significant being that the structure is not very efficient as any income and gains earned by the CFC are deemed to be distributed to the fund as net investment income (no capital gain treatment), and any losses incurred by the CFC are deferred until the position in the CFC is eliminated.  Additionally, this will be a bit of a headache for the fund administrator, which I’m sure is foremost in the minds of the investment advisor.