Statement of
Matthew P. Fink
President, Investment Company Institute

On H.R. 1089,
"The Mutual Fund Tax Awareness Act of 1999"

Before the
Subcommittee on Finance and Hazardous Materials,
Committee on Commerce,
U.S. House of Representatives

October 29, 1999

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Table of Contents

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I. Summary
1. The Investment Company Institute strongly supports the bill's objective to improve "after-tax" disclosure to investors. Mutual fund shareholders should understand the impact that taxes can have on returns generated in their taxable accounts. Indeed, ensuring such understanding is entirely consistent with the Institute's long-standing support for initiatives to improve disclosure to investors.

2. The Institute has been discussing the relevant computational and disclosure issues with the bill's sponsors and the SEC. While some of these issues are surprisingly complex, the SEC is likely to issue a proposal in the near future.

3. A threshold matter that the SEC will have to resolve is whether it would be best to expand upon the existing required disclosure, or to require funds to calculate one or more after-tax return numbers.

4. If an after-tax return number is proposed, perhaps the most significant computation issue is whether the return should be computed on a pre-liquidation basis (assuming that the investor continues to hold his shares at the end of the measurement period), or on a post-liquidation basis (assuming that the investor redeems his shares at the end of the measurement period).

A pre-liquidation after-tax return is intended to disclose the tax effects only of actions taken by the fund, by reflecting the tax impact of distributions made by the fund during the measurement period(s).

A post-liquidation after-tax return also reflects the potential impact of taxes on (i) unrealized appreciation in the fund's portfolio and (ii) realized but undistributed capital gains.

5. Other significant issues involve the applicable federal and/or state income tax rates to be used in calculating after-tax returns.

6. After-tax return numbers must be accompanied by disclosure that informs investors of their appropriate use and inherent limitations. Otherwise, investors could misunderstand them, and even be misled.

7. While taxes are an important consideration for investors purchasing fund shares in their taxable accounts, other factors also are important.

8. After-tax returns vary from investor to investor, depending on each investor's federal and state tax rates and own individual circumstances. For some investors, such as those who hold fund shares in IRAs or 401(k) plans, after-tax returns will have no relevance.

9. After-tax return numbers are not predictive. Among other things, future behavior of some fund shareholders (e.g., redemption activity) can have a significant impact on other shareholders' after-tax returns.

II. Oral Statement of Matthew P. Fink
My name is Matthew P. Fink. I am President of the Investment Company Institute, the national association of the American investment company industry. We appreciate the opportunity to testify today on H.R. 1089, the "Mutual Fund Tax Awareness Act of 1999," which has been sponsored by Representatives Gillmor and Markey, and nine other members of the House Commerce Committee. The legislation directs the SEC to develop a rule to require mutual funds to disclose the effects of taxes on returns to fund investors.

The Investment Company Institute strongly supports the bill's objective to improve disclosure to shareholders about the effect of taxes on a mutual fund's performance. Mutual fund shareholders who have taxable accounts need to better understand the impact that taxes can have on the returns generated by their investments. Indeed, ensuring a strong understanding of the tax consequences of fund investing is entirely consistent with the Institute's long-standing support for initiatives to improve disclosure to investors.

The Institute has been actively discussing the relevant issues associated with after-tax returns with the bill's sponsors and the SEC. While some of these issues are surprisingly complex, the SEC is likely to issue a proposal in the near future. I want to emphasize that the Institute looks forward to continuing our work with the SEC to resolve swiftly these important issues. Once that is accomplished, we expect to see a final SEC rule that will meet the needs of fund investors, satisfy the expectations of the bill's sponsors, and enjoy the strong support of the fund industry.

As you know, a threshold matter that the SEC will have to resolve is whether it would be best to expand upon the existing required tax-related disclosures in prospectuses and shareholder reports, or to require funds to calculate one or more after-tax return numbers.

If an after-tax return number is used, perhaps the most significant computation issue is whether the return should be computed on a pre-liquidation basis, which assumes the investor continues to hold all shares at the end of the measurement period; or on a post-liquidation basis, which assumes the investor redeems all shares at the end of the measurement period; or whether both figures should be prepared.

A pre-liquidation figure is intended to disclose the tax effects only of actions taken by the fund, by reflecting the tax impact of distributions made by the fund during the measurement period.

A post-liquidation figure also reflects the potential impact of taxes on unrealized appreciation in the fund's portfolio.

Other significant issues to be resolved involve the applicable federal and/or state income tax rates to be used in calculating after-tax returns.

It is also extremely important that after-tax return numbers be accompanied by textual disclosure that informs investors of their appropriate use and inherent limitations. Otherwise, investors could misunderstand them, and even be misled.

Investors will need to know that actual after-tax returns will vary from investor to investor, depending on each investor's federal and state tax rates and own individual circumstances. Of course, for investors who hold fund shares in IRAs, 401(k) plans, or other non-taxable accounts, after-tax returns will have no relevance.

Perhaps most significantly, investors must understand that after-tax return numbers are not predictive. For example, a fund that has been highly tax efficient in the past could easily have significant taxable distributions in the future, in part because the size, scale, and timing of such distributions are sometimes beyond the control of the fund's manager.

Finally, even though taxes are an important consideration for investors purchasing fund shares in their taxable accounts, investors need to be reminded that other factors also are important.

We are confident that these issues will be promptly and successfully resolved through the SEC's rule-making process. We thank you for your leadership in this area, and look forward to continuing to work with you and the SEC to achieve a result that will benefit millions of fund shareholders.

III. Introduction
My name is Matthew P. Fink. I am the President of the Investment Company Institute, the national association of the American investment company industry.¹

I appreciate the opportunity to testify today on H.R. 1089, the "Mutual Fund Tax Awareness Act of 1999." This bill, introduced by Representatives Gillmor, Markey, and nine co-sponsors, would direct the Securities and Exchange Commission ("SEC") to develop a rule to require mutual funds to disclose the effects of taxes on returns to fund investors.

The Institute thanks you for giving us the opportunity to work with you on this legislation. Ensuring that mutual fund investors understand the impact that taxes can have on returns generated in their taxable accounts is entirely consistent with the Institute's long-standing, strong support for initiatives to improve disclosure to investors.

The industry has taken several steps to promote the disclosure improvements sought by the legislation. Following the introduction last year of similar legislation, the Institute formed a task force of its members to develop approaches for identifying and resolving the complex issues associated with disclosing after-tax returns. The industry has had discussions with Mr. Gillmor, Mr. Markey, others of you, and the SEC regarding after-tax return disclosure issues. We submitted materials to the SEC in July regarding possible methodologies for calculating after-tax returns.

We understand that the SEC staff is actively considering this matter. The Institute is committed to working with the Congress and the SEC as this process moves forward toward completion.

The remainder of my testimony provides background on the tax aspects of investing in mutual funds, a summary of current disclosure requirements, and finally a discussion of approaches to after-tax disclosure and issues raised by these approaches.

IV. Tax Aspects of Mutual Fund Investing
A mutual fund shareholder invested in a taxable account may be taxed on his investment in two ways: first, when the fund distributes its income and net realized gains (whether received in cash or reinvested in additional shares); second, when the investor redeems fund shares at a gain (whether received in cash or exchanged for shares in another fund).

A. Distributions to Shareholders
The timing and character of mutual fund distributions is governed by the Internal Revenue Code. The Code effectively requires a mutual fund to distribute all of the income and net gains from its portfolio investments annually. A fund's distributions may be taxable to the shareholder in two different ways: (1) as ordinary income (e.g., dividends, taxable interest, and net short-term capital gains) or (2) as long-term capital gains (i.e., capital gain dividends attributable to net long-term capital gains). This is the case whether the shareholder takes his distributions or reinvests them. Distributions also may be exempt from tax (e.g., exempt-interest dividends attributable to tax-exempt interest).

The amount of mutual fund distributions can be affected by a fund's investment policies and strategies (e.g., depending on whether it has a policy of actively trading its portfolio) and by factors outside the control of the fund's investment adviser. For example, a fund that experiences net redemptions can be forced to sell portfolio securities to meet redemptions and thereby realize gains that it otherwise would not.

B. Redemptions by Shareholders
Redemptions (sales) of mutual fund shares result in taxable gain (or loss) to the redeeming investor (whether the proceeds are received in cash or exchanged for shares of another fund). This gain or loss is based upon the difference between what the investor paid for the shares (including the value of shares purchased with reinvested dividends) and the price at which he sold them.

All of a fund investor's economic return ultimately is received either as a distribution or as redemption gain. Consequently, there is a clear inverse relationship between these two tax consequences. If a fund makes relatively lower distributions because it does not realize its gains, gains build up in the fund. Consequently, a redeeming shareholder will have larger capital gains upon redemption than he otherwise would have had if the fund had realized and distributed the gains.²

C. Nontaxable Accounts
It is important to note that the tax impact discussed above is not applicable in the case of investors that hold their mutual fund shares in a tax-deferred account, such as a qualified employer-sponsored retirement plan (e.g., a 401(k) plan), or an Individual Retirement Account. As of year-end 1998, 45% of all mutual fund assets (other than money market funds), and 50% of all equity fund assets, were held in a tax-deferred account.³

V. Current Disclosure Requirements
The SEC currently requires that the general tax effect of investing in mutual funds be disclosed to investors in a plain English narrative in a fund's prospectus. Mutual funds are required to describe "the tax consequences to shareholders of buying, holding, exchanging and selling the Fund's shares," including, as applicable, specific disclosures that distributions from the fund may be taxed as ordinary income or capital gains, that distributions may be subject to tax whether they are received in cash or reinvested, and that exchanges for shares of another fund will be treated as a sale of the fund's shares and subject to tax.⁴ Any fund that may engage in active and frequent trading of portfolio securities also is required to explain the tax consequences of increased portfolio turnover, and how this may affect the fund's performance.⁵

All funds are required to provide investors with other information that may reflect the tax consequences of investing, including the fund's portfolio turnover rate and the amount of its net unrealized gains.⁶ The financial highlights table, which is required to be included in fund prospectuses and annual reports, also contains information on a fund's distributions, including distributions attributable to income and to realized gains.⁷

VI. Issues for SEC Consideration
The Institute agrees with the intent of H.R. 1089 and supports the approach taken under H.R. 1089, which leaves after-tax disclosure to SEC rulemaking. Development of this disclosure will require the consideration of several surprisingly complex issues, some of which may not be immediately apparent. Thus, this issue is a good candidate for the rulemaking notice and comment process, where especially complex issues can be resolved.

A. Improved Narrative Disclosure vs. Providing One or More After-Tax Return Numbers
A threshold matter that the SEC will have to consider is whether to expand upon the existing required disclosures, or to require funds to calculate one or more after-tax return numbers. On the one hand, an after-tax number might appear more straightforward, as it would not require a shareholder to review financial statements and apply the correct tax rates in order to determine the effects of taxes upon his return. In this way, it also might facilitate the ability of shareholders to compare different funds.

On the other hand, an after-tax number could have inherent limitations. As described more fully below, in order to compute an after-tax number, funds will have to make a series of assumptions, many of which may not be applicable to any particular shareholder. This runs the risk of inadvertently misleading investors. It also should be noted that other financial products, including ones that compete with mutual funds, are not required to disclose their after-tax returns and thus comparisons between competing products will not be possible.⁸

Assuming the SEC determines that it is appropriate to require funds to disclose an after-tax return number, two types of issues will have to be addressed. The first relates to the actual computation of after-tax return(s). The second relates to the need to ensure investor understanding of this information.

B. Computational Considerations
1. After-Tax Calculations on a Pre-Liquidation and/or Post-Liquidation Basis. Perhaps the most significant computation issue is whether any after-tax return formula should assume that the investor continues to hold, or instead redeems, his shares at the end of the period for which the return is being calculated. If the formula assumes that he holds the shares (the "pre-liquidation calculation"), the after-tax return would be calculated by reducing the fund's total return by the tax due on distributions made during the measurement period. If the formula assumes that he redeems the shares (the "post-liquidation calculation"), the return would be further adjusted to reflect capital gains (or possibly capital losses) that would be realized upon redemption.

The first (pre-liquidation) alternative is intended to disclose the tax effects only of actions taken by the fund, by reflecting the tax impact of distributions made by the fund during the measurement period(s). The second (post-liquidation) alternative, in contrast, also reflects the potential impact of taxes on (1) unrealized appreciation in the fund's portfolio and (2) realized but undistributed capital gains. It thus better discloses an investor's total potential tax exposure but, in order to do so, assumes that the investor will redeem his shares at the end of the measurement period, which will probably not be the case.

2. Federal and State Tax Rate Assumptions. Other significant issues involve the assumptions regarding applicable federal and state income tax rates to be used (or not used) in calculating after-tax returns. For example, which federal tax rate should be applied to income distributions? As a preliminary matter, the Institute believes that it may not be appropriate to apply the top federal tax rate (currently 39.6%) to } fund distributions, since this rate currently applies to individuals with a taxable income of more than $283,150, while the median income of mutual fund shareholders is approximately $55,000.⁹ Another issue is whether current or historical rates should be used. For example, if a fund were computing its 10-year after-tax return, should it apply the 1990 income tax rates to distributions made in 1990, or the present day rates? Finally, the SEC will have to consider whether other taxes, such as state tax, should be reflected; because of the complexity, the Institute believes that they should not.¹⁰

C. Ensuring Investor Understanding of the Information
The after-tax return numbers must be accompanied by disclosure that informs investors of their appropriate use and inherent limitations. Otherwise, investors could misunderstand them, and be inadvertently misled as to the impact of taxes on their returns.

1. After-Tax Returns Vary From Investor to Investor. It must be clearly disclosed to fund investors that after-tax returns will vary significantly from investor to investor (unlike pre-tax total returns, which are equally relevant for all investors in a fund for the measurement period).¹¹ Thus, any after-tax return disclosed by a fund may not, and probably will not, reflect a fund shareholder's own individual circumstances. There are as many after-tax returns for a given pre-tax return as there are possible combinations of potentially applicable federal and state tax rates. In addition, different investors in the same fund may be more or less tax-sensitive depending, for example, on an investor's ability to offset distributed capital gains against unrelated, realized losses. And, for some investors-such as those who hold fund shares in IRAs or 401(k) plans-after-tax returns will have no relevance.

2. After-Tax Return Numbers Are Not Predictive. There are "predictive" limitations to an after-tax return number. As noted above, the future behavior of some fund shareholders (e.g., redemption activity) can have a significant impact on other shareholders' after-tax returns. In addition, "good" past after-tax returns could mean that the shareholder has more potential tax exposure in the future. If most of a fund's gains were unrealized, those gains could lead to greater distributions in the coming years.

Thus, the Institute would recommend inclusion of a cautionary legend, similar to that required for total pre-tax return data, disclosing that an after-tax return number reflects past tax effects and is not predictive of future tax effects.

3. Taxes Are One of Many Important Factors When Making Investment Decisions. While taxes are an important consideration for investors purchasing fund shares in their taxable accounts, other factors also are important. For example, investors purchase bond funds to receive current distributions of interest income, taxable at federal tax rates up to 39.6% (except in the case of municipal bond funds). A taxable investor's goal should be, consistent with his investment objectives, to maximize after-tax returns rather than to minimize taxes.

VII. Conclusion
The Institute appreciates the opportunity to testify before the Subcommittee. We support the objectives of the "Mutual Fund Tax Awareness Act of 1999" to improve disclosure to investors of tax effects on mutual fund total returns. We will continue to work with the Congress and the SEC in order to achieve a result that will be most useful for our 77 million shareholders.

¹The Investment Company Institute is the national association of the American investment company industry. Its membership includes 7,729 open-end investment companies ("mutual funds"), 485 closed-end investment companies, and 8 sponsors of unit investment trusts. Its mutual fund members have assets of about $6.010 trillion, accounting for approximately 95% of total industry assets, and over 78.7 million individual shareholders.

²For example, consider two funds (A & B) each of which has a $10.00 net asset value ("NAV") at the beginning of the measurement period and an $11.00 NAV at the end of the period (before distributions). The $1 increase in NAV represents a 10% return for the measurement period. Further assume that Fund A distributes $0.20 per share and Fund B distributes $0.40 per share on the last day of the measurement period. An investor in Fund A receives 20% of the return in the form of a $0.20 per-share taxable distribution, with the remaining 80% of the return presently untaxed in the form of an $0.80 increase from the original $10.00 NAV. An investor in Fund B, in contrast, receives 40% of the return in the form of a $0.40 per-share taxable distribution, with the remaining 60% of the return presently untaxed in the form of a $0.60 increase from the original $10.00 NAV.

³Source: ICI data used in publishing 1999 Mutual Fund Fact Book (39th ed.).

⁴See Item 7(e) of Form N-1A. There are also special disclosures required of tax-exempt funds.

⁵See Instruction 7 to Item 4(b)(1) of Form N-1A.

⁶Portfolio turnover rate is included in the fund's financial highlights table (see Item 9(a) of Form N-1A); net unrealized gains are reported in the fund's financial statements (see Rule 6-05 of Regulation S-X). As was noted recently in Morningstar FundInvestor, however, a fund's portfolio turnover and potential capital gains exposure are at best only loosely correlated with the level of a fund's taxable distributions. See Morningstar FundInvestor, Vol. 8 No. 1, September 1999.

⁷See Item 9(a) of Form N-1A.

⁸The SEC may decide to require some funds, but not all, to disclose their after-tax returns. The SEC could either exempt some funds, such as money market funds or funds sold principally to tax-deferred accounts, or only apply the requirement to certain types of funds, such as funds that hold themselves out as "tax managed."

⁹Source: ICI 1999 Mutual Fund Fact Book (39th ed.), p. 45.

¹⁰Other computational issues are noted in the attached Institute letter to the SEC. [Ed. Note: omitted here.]

¹¹Under the SEC's methodology for calculating pre-tax total return, which assumes a hypothetical $1,000 investment and the reinvestment of all fund distributions, all investors in the fund throughout the measurement period will have the same return (provided they have the same account transactions-e.g., all dividends are reinvested, no other share purchases occur, and no shares are redeemed).