Investment Company Notebook
To Defer or Not to Defer
The Regulated Investment Company (“RIC”) Modernization Act of 2010 (the “Act” or “RIC Mod”) brought an array of changes beneficial to RICs. Certain of these changes allow RICs more flexibility in electing whether or not to defer or to recognize in the current taxable year certain “late year losses.” Late year losses is a new term introduced into tax parlance by RIC Mod which encompasses all post-October net capital losses, losses on certain enumerated items of ordinary income (such as code section 988 foreign currency losses and the decline in value in an investment in a passive foreign investment company (“PFIC”)) and post-December ordinary losses not so enumerated.
In an effort to minimize discrepancies between a RIC’s excise period taxable income and its fiscal period taxable income, the pre-RIC Mod Internal Revenue Code (IRC) has traditionally allowed a RIC to make certain loss deferrals in the computation of its taxable income. This would include the deferral of the capital losses, foreign currency losses, and the decline in value in an investment in a PFIC occurring after October 31 through to the RICs fiscal year-end.
Before the enactment of RIC Mod, certain deferrals (such as the post-October capital loss deferrals) were mandatory for purposes of capital gain dividend designation, but were elective for the purpose of computing the RIC’s taxable income. As a practical matter, most RICs would defer the post-October losses for dividend designation as well as for taxable income computation. If a RIC would have deferred the post-October losses for dividend designation purposes but not for purposes of computing its taxable income, various undesirable circumstances could result. In addition, by deferring the post-October capital loss to the following year, a RIC would effectively gain one additional year in which those losses could be utilized over and above the pre-RIC Mod eight year capital loss carry forward expiration period. Before the Act, deferring post-October losses would have been beneficial for a RIC in virtually all situations. RIC Mod changes the operation of the late year loss (including post-October capital loss) deferral rules so that elections to defer or not to defer late year losses are effective in the same way for both dividend designation purposes and taxable income computation purposes. This change affords RICs in a post-RIC Mod year much more flexibility in electing whether to defer or not to defer late year losses. Such elections can be made without incurring the undesirable tax consequences that could result under pre-RIC Mod tax law.
The following two examples highlight the disconnect between the pre-RIC Mod rules on automatic deferral of post-October capital losses for dividend designation purposes vs. the elective deferral for income tax purposes and some of the undesirable consequences that can occur.
Let’s assume that Fund A (pre-RIC Mod period), with a year ended June 30, 2011, had $15,000 of short-term capital gain and $10,000 of long-term capital loss, all occurring in the post-October 31, 2010 period and no other income, expenses, gains or losses during the year. For capital gain dividends designation purposes, the $10,000 of long-term loss was automatically deferred to the next fiscal year. However, for purposes of determining the fund’s taxable income for fiscal year June 30, 2011, such election was not mandatory If no deferral election was made for taxable income purposes, the fund would have been required to pay $5,000 in ordinary income dividends for the year ended June 30, 2011, in order to avoid an income tax.
For the year ended June 30, 2012, the fund had a $10,000 loss deferral carryover for dividend designation purposes and no carryover for income tax purposes. If the fund had a $20,000 long-term gain realized in the year ended June 30, 2012 (and no other income, deductions, gains or losses), it could have designated only $10,000 of such gain as long term capital gain dividends (after netting the deferral carryover), although the fund had realized $20,000 in long-term gains that year. If it had distributed $20,000, it could only have designated $10,000 as a long-term capital gain distribution, and the $10,000 balance of long-term capital gains would have been taxed. Further, the remaining $10,000 in dividends paid could not have been deducted against ordinary income, since there would have been no ordinary income. It would, however, have been taxable to shareholders as ordinary income, since the fund would have enough earnings and profits to support it.
If the election to defer post-October losses was made in the year ended June 30, 2011, for income tax purposes, the fund would have needed to distribute $15,000 in ordinary income dividends, even though economically those short-term gains were partially offset by the long-term loss. In the year ended June 30, 2012, it would have needed to distribute $10,000 in long-term capital gain distributions. The net effect is that over the two year period, the fund would have distributed $15,000 in ordinary income dividends and $10,000 in long term gain distributions in either scenario. However, if the deferral election was not made, the fund would have incurred capital gains tax on $10,000 that it would not have incurred if the election was made. This would clearly be an undesirable result.
Under post-RIC Mod rules, if the fund elected not to defer the post-October 31, 2010 long term capital loss for income tax purposes, the election also would have been effective for dividend designation purposes. In such a scenario, the fund would have distributed a $5,000 ordinary income dividend for the year ended June 30, 2011 and could have designated the entire $20,000 long-term gain recognized in the year ended June 30, 2012 as a long-term capital gain distribution, a much more desirable result then under the pre RIC Mod rules.
Let’s assume that Fund B (pre-RIC Mod period), with a tax year ended June 30, 2011, had $10,000 of long-term gain through the period ended October 31, 2010 and $4,000 long-term capital loss for the period November 1, 2010 through its fiscal year-end, and no other income, deductions, gains or losses for the year. A $10,000 long-term capital gain dividend was paid in December of 2010 to meet the excise distribution requirement for calendar year 2010. For dividend designation purposes, the fund had $10,000 of long-term capital gain, because the post-October capital loss was automatically deferred. For income tax purposes, if the fund did not elect to defer the $4,000 post-October capital loss, its net capital gain (and earnings and profits) for the year ended June 30, 2011 was $6,000. That means that $4,000 of the distributions paid in December 2010was return of capital. Since a return of capital is not technically deductible for excise tax purposes, this scenario causes an excise tax under distribution (and therefore an excise tax liability) for calendar year 2010, despite the fact that shareholders received 1099 forms reporting, and were taxed on, $10,000 in long-term capital gain distributions. The Forms 1099 issued for 2010 improperly reflected $4,000 as long-term capital gain dividends rather than return of capital and technically should have been amended. If the fund had elected to defer, then it would have had a $10,000 long-term gain distribution requirement for income tax purposes and could have designated this amount as long-term gain dividends, and excise and fiscal year taxable income would have been in harmony.
Assume that for the fiscal year ended June 30, 2012, the fund had $4,000 in long-term capital gain in the pre-November period and no other income, deductions, gains or losses. In the scenario where the fund elected not to defer, it would have had a $4,000 distribution requirement in order to avoid a tax on the long-term gains. However, since deferral was required for dividend designation purposes, it would have no long-term gains to designate, in that the deferred loss for designation purposes would have offset the long-term gains for the year. As a consequence, it would therefore have been taxed on $4,000 of long-term gain. If the fund distributed this amount, the distribution would have been taxable as ordinary income to shareholders, since it had $4,000 of earnings and profits to support the dividend. This amount would have had to be distributed in order to avoid further imposition of the excise tax in calendar year 2011on the amount deemed undistributed in calendar year 2010, due to the return of capital.
In the deferral scenario, the deferred loss would net with the long term gain, and there would be no distribution requirement. In summary, over the two year period, in the deferral case, the fund would have distributed $10,000 with all of it treated as long-term gain dividends. In the non-deferral case, the fund would have distributed $14,000 with $6,000 treated as long-term capital gain, $4,000 treated as return of capital and $4,000 treated as ordinary income. In addition, the fund would pay an excise tax for 2010 on the technically undistributed amounts due to the return of capital and a long-term gains tax. Not a desirable situation.
Applying the post-RIC Mod rules to this example, if the fund elected not to defer in the fiscal year ended June 30, 2011, its December 2010 dividend would still be deemed in part a $4,000 return of capital, and the excise tax problem would still exist. However, in the fiscal year ended June 30, 2012, there would be no deferred loss from the previous year for designation purposes, and therefore the $4,000 dividend in that year would have been a long-term capital gain distribution as opposed to an ordinary income dividend, a slightly better result than under the pre-RIC Mod rules.
The following examples highlight situations where under post-RIC Mod rules, it may be beneficial not to defer post-October losses:
Let’s assume that Fund C (post-RIC Mod period), with a tax year ended December 31, 2011, has a $100,000 short-term capital loss carryover (pre-RIC Mod) from December 31, 2010, a net long-term capital loss of $50,000 for the current year, and a $30,000 post-October 31, 2011, long-term capital loss. The fund therefore had no need to pay capital gain dividends during 2011. In this scenario, since there is no need to be concerned with dividends already paid out being recast as return of capital, the fund has no benefit in deferring its $30,000 of its post-October capital loss. Under the pre-RIC Mod rules, the fund would still want to defer its $30,000 of post-October loss until January 1, 2012, in order to gain one extra year in its expiration schedule. Post-RIC Mod capital losses do not expire; so therefore the post October deferral becomes irrelevant for this scenario. This is particularly true in light of the fact that under the Act, post-RIC Mod loss deferrals are treated the same for dividend designation purposes as they are for income tax purposes.
Let’s assume that Fund D has ordinary income of $10,000 for its year ended December 31, 2011, and a post-October Section 988 and PFIC loss of $3,000. Further assume that the fund did not make any distributions during 2011. In this case, the fund has a potential excise under distribution subject to excise tax. In this scenario, it would benefit the fund not to defer the $3,000 of post-October Section 988 and PFIC losses, and use them in the year ended December 31, 2011 to reduce the spillback requirement and minimize the excise under distribution and tax for 2011.