Can Funds Use Equalization Debits and In-Kind Redemptions Together For Tax Efficiency?

Posted by admin on Aug 5, 2014 4:26:00 PM

In order to achieve tax efficiency and maintain the single layer of taxation concept of Subchapter M, regulated investment companies (RICs) use various techniques. Two common techniques in the industry are equalization debits and the use of redemptions in-kind instead of cash redemptions. ETFs tend to use in-kind redemptions more than non-ETF groups.

financesEqualization Debits

Equalization debits refer to the allocation of a share of a fund's accumulated earnings and profits to redemptions made during the year and the deemed distribution of such earnings and profits. A shareholder redeeming from a fund before a distribution date will not receive a Form 1099 for his or her allocable share of the fund's earnings and profits. The "equalization debits" method attempts to alleviate the unfair tax burden of remaining shareholders by allocating some of the fund's earnings and profits to redemptions made throughout the year. While the use of equalization is not sanctioned in the tax code, the concept of equalization and its merits have been acknowledged by the IRS in revenue and private letter rulings.

In-Kind Redemptions

For property distributions by a RIC, the tax code, in Section 852(b)(6), provides an exception from corporate level gain or loss recognition. The non-recognition exception applies only to distributions made in redemption of RIC stock and upon the demand of the shareholder. Therefore, a fund can avoid generating taxable gains from sales of securities by distributing securities to shareholders in order to meet redemption requests. Such gains would otherwise be distributed to all shareholders.

Can Both Methods Be Used at the Same Time?

An interesting scenario arises when a fund uses, or attempts to use, both methods. There is some debate as to the interaction between these two tax minimization techniques.

Since a corporation's earnings and profits are increased by gains from distributions of appreciated property (Sec 312(b)), and gains on in-kind redemptions are part of a corporation's economic income, some authors argue that such gains on in-kind redemptions should be part of earnings and profits and available for computing equalization debits. While in theory this approach has some merit, especially for a corporation organized under Subchapter C of the Code, its application to a RIC presents some practical issues.

As mentioned above, equalization intends to alleviate some of the tax burden on shareholders of a RIC by allocating earnings and profits to redemptions early in the year. However, the use of in-kind redemptions achieves the same end result by "pushing" unrealized gains, tax-free, on to the redeeming shareholders. Those gains on in-kind redemptions are not included in a RIC's taxable income and would not affect the remaining shareholders of a RIC, and, as such, they should not be part of earnings and profits available for equalization debits. This approach is supported by Section 312(f), which states that gains such as gains on in-kind redemptions increase a corporation’s earnings and profits only to the extent that they are included in that corporation's taxable income.

Additionally, by including gains on in-kind redemptions in its earnings and profits available for equalization, a RIC could potentially eliminate its entire taxable income by using equalization debits and not be required to make any dividend distributions. It is widely agreed in the industry that a RIC should not be able to eliminate its entire taxable income by using equalization, except in a liquidation. The equalization debits were not designed to help a RIC eliminate its earnings, but to proportionally reduce its earnings to reflect the earnings and profits that are attributable to stock redemptions during the year.

Given the above, our view is that the two methods can be used in the same year. However, a RIC should be aware of the potential overlapping areas and account for them accordingly, so that earnings utilized under one method are not double counted by inclusion in the other method.

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