Investment Company Notebook

Practical insight and analysis on the accounting, audit and tax issues impacting investment companies.

Considerations For Mutual Funds For Allocating Earnings and Profits to Distributions

In this post, we’ll consider the following:

  • Current requirements, as updated by the RIC Modernization Act of 2010, for allocating earnings and profits across multiple distribution dates in instances where total annual distributions exceed earnings and profits for funds that have fiscal year ends that span two calendar years (e.g.  non-calendar fiscal year end funds)
  • Why this requirement may impact the reporting of distributions in a semi-annual report

Calculating_Semi-Annual Report_Mutual Fund

Current Requirements for Allocating Earnings and Profits

Distributions of a Regulated Investment Company (“RIC”) are deemed to be comprised of earnings and profits (“E&P”), to the extent there are any, and if in excess of E&P, as a return of capital (“ROC”).  It is worth mentioning that a RIC is required to measure its E&P at the end of its fiscal year.  Prior to the RIC Modernization Act of 2010 (“RIC MOD”), a RIC that paid multiple distributions that, in the aggregate, exceeded its E&P, would allocate its E&P ratably over each distribution. 

A simple example will illustrate this approach.  Assume a June 30 fiscal year-end RIC paid $100 per month in distributions over the course of its fiscal year, but only had $600 of E&P.  Under the previous rules, each monthly distribution would be deemed to have been comprised of $50 E&P and $50 of ROC, regardless of when the E&P was actually earned during the year.  While this approach was simple, there were certain situations that would arise, in coordination with the excise tax rules, whereby a RIC would need to make a distribution to avoid excise tax, but would not have E&P available from which to pay the distribution.  This would effectively trap a RIC into an unavoidable excise tax situation.

In an effort to correct this unfair and potentially unavoidable situation, the RIC MOD imposed a change in the method of allocating E&P across multiple distributions.  Under the RIC MOD, for RICs with fiscal years that span two calendar years, E&P is first allocated to distributions in the beginning of its fiscal year (first calendar year), then to the distributions in the second calendar year, if any E&P remains.  Circling back to the example in the previous paragraph, under the RIC MOD, the distributions for the first six months (July – December) would be deemed to be 100% from E&P, even though the fund likely did not have that much E&P at the time of the distributions.  Additionally, the distributions for the second six months (Jan – June) would be deemed to be 100% ROC, even though the fund likely had earned E&P over that time period. 

While this change alleviated the unavoidable excise tax situation described above, there is an element of potential unfairness to this method.  Depending on the timing of purchases and sales of fund shares, a shareholder’s distributions potentially could be allocated more a less taxable income than that shareholder may have logically earned over the period of their investment.  In the example above, if a shareholder purchased shares in July and sold them in December, all of their distributions would be from E&P and taxable, although logically the fund would not likely have had that much E&P over that time period. Conversely, the 1099 for shareholders who purchased their shares in January would show no taxable income.

The Impact of E&P Allocation Rules on the Reporting of Distributions in a Semi- Annual Report

If you were to read the accounting policies in the notes to the financial statements for most mutual funds, you would note that the accounting policy for distributions says something to the effect of “Distributions to shareholders are recorded on the ex-dividend date and determined in accordance with Income Tax Regulations.”  With this as a foundation, some funds apply the RIC MOD E&P allocation approach when reporting their distributions in the Statement of Changes in Net Assets. 

Consider the example above, but we will take a snapshot at the semi-annual date (12/31) and assume the fund paid $600 in distributions, but only earned $200 in net investment income.  However, the fund was growing, and management firmly believed the fund would earn at least $600 by the end of the fiscal year (6/30).  Under these assumptions, the fund may have a case for reporting all $600 of their distributions to shareholders as distributions from net investment income, even though the same annual report will only show $200 of net investment income.  The premise for this case is that reporting the distributions in this manner will align the semi-annual report with how the amounts are reported on shareholders’ 1099s and is in accordance with income tax regulations.  I refer to the example above of a shareholder purchasing shares on 7/1 and redeeming them on 12/31.  The 1099 for such a shareholder, using the assumptions described above, would show 100% of the distributions received as taxable distributions.  If the fund were to report the distributions economically ($200 from net investment and $400 from ROC), such a shareholder may question why their 1099 does not reflect the amounts reported in the Semi-Annual Report.