Tax Simplification Proposals Impacting Registered Investment Companies 
(H.R. 4337)

Hearing Before the Subcommittee on Select Revenue Measures of the 
Committee on Ways & Means of The U.S. House of Representatives
Statement of William M. Paul on Behalf of the Investment Company Institute

Washington, DC
June 15, 2010

Mr. Chairman and Members of the Committee:

My name is William M. Paul. I am a partner with the law firm of Covington and Burling LLP. I appear before you today on behalf of the Investment Company Institute (“ICI”), the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (“ETFs”), and unit investment trusts (“UITs”). Members of ICI manage total assets of $11.97 trillion and serve almost 90 million shareholders.

I appear today to discuss H.R. 4337, “The Regulated Investment Company Modernization Act of 2009” (the “Bill”). The Bill was introduced last December by Mr. Rangel along with three co-sponsors on this Committee. The ICI very much appreciates your leadership, Mr. Chairman, as a co-sponsor of the Bill, as well as that of Mr. Rangel, Mr. Crowley and Ms. Schwartz.

The Bill would modernize the tax rules for regulated investment companies (“RICs”) to reflect numerous developments in recent years. The statutory provisions applicable to RICs have not been updated in any meaningful or comprehensive way since 1986, some 24 years ago. Indeed, some of the provisions in current law date back more than 60 years. The changes made by the Bill would benefit millions of mutual fund investors by improving the efficiency of mutual fund investment structures, reducing disproportionate tax consequences for inadvertent errors, and minimizing the need for amended tax statements and amended tax returns.

My testimony is divided into three parts. Part I provides some background on the existing statutory framework applicable to RICs. Part II summarizes various developments in recent years that necessitate changes to the relevant tax rules. Part III describes several illustrative provisions in the Bill.

I. Existing Statutory Framework Governing the Taxation of RICs and Their Shareholders

The special tax regime applicable to RICs and their shareholders is found in Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”). The basic framework of Subchapter M originated in the Revenue Act of 1936 and developed into substantially its present form in 1942.

In order to qualify as a RIC under Subchapter M, an investment company must satisfy a number of requirements. First, investment companies -- such as mutual funds, closed-end funds and ETFs -- can qualify under Subchapter M only if they are registered under the Investment Company Act of 1940. As registered investment companies, these funds are subject to extensive regulation by the Securities and Exchange Commission (the “SEC”). Second, RICs must have at least 90 percent of their gross income from qualified sources, such as interest, dividends and gains on the sale of securities. Third, RICs must meet certain asset diversification tests. Finally, RICs must distribute at least 90 percent of their income to their shareholders on a current basis.

If RICs satisfy these requirements they are allowed a deduction for dividends paid to shareholders. RICs typically strive to distribute 100 percent of their income and gains to shareholders so that there will be no tax at the entity level. Qualifying RICs are also able to pass through certain tax attributes to their shareholders. For example, a RIC with net capital gain for the year can distribute capital gain dividends to its shareholders and shareholders report these distributions as long-term capital gains. Similar pass-through treatment applies to tax-exempt interest earned by a RIC as well as to credits for foreign taxes paid by a RIC on investments in foreign securities.

The distribution requirements of Subchapter M are tied to the RIC’s taxable year, and most RICs have tax years other than the calendar year. In order to address potential deferral of income to RIC shareholders, most of whom are individuals, Congress adopted a separate and additional distribution requirement in 1986 that is tied to the calendar year. Under Code section 4982, a RIC is required to distribute to shareholders substantially all of its income and gains in the calendar year in which they are earned. Any shortfall in meeting this requirement is subject to a four percent excise tax at the RIC level. Unfortunately, the rules that attempt to coordinate Subchapter M with the calendar-year distribution requirements of section 4982 are incredibly complex, and, as the industry has learned by experience since 1986, deficient in various respects.

To round out the picture, I should note that RICs are corporations for federal income tax purposes, and thus they are also subject to the provisions of Subchapter C of the Code. Given the unique nature of RICs, however, a number of the rules in Subchapter C do not yield sensible results when applied to RICs and the rules have therefore been modified in some respects in their application to RICs.

II. Developments

In the past 20 or more years, numerous developments have placed stress on the current tax rules for RICs. In various respects, the rules do not work properly, unnecessarily restrict innovation, and are subject to increased uncertainty in their application. H.R. 4337 attempts to address as many of these situations as possible, but only to the extent that can be accomplished with minimal revenue impact.

One area that has seen significant evolution since the 1986 Act is the development of new investment structures in the fund industry. One prominent example is the “fund of funds” structure. This structure consists of a fund (sometimes referred to as the “upper-tier fund”) that invests exclusively or primarily in a number of other mutual funds (referred to as “lower-tier funds”) within the same complex. These structures were developed in response to the increasing desire on the part of investors for asset allocation services, particularly for retirement savings. One popular type of fund of funds, referred to as a target date fund, automatically rebalances the allocation of its investments in various lower-tier funds to adjust the risk profile of the investments as the investor approaches retirement age. Target date funds and other funds of funds currently hold total assets of roughly $750 billion.

A second example of the evolution in fund structures is the emergence of funds with multiple share classes. Unlike separate series of stock, which represent interests in different portfolios, these classes represent interests in the same portfolio, but typically have differences in expense allocations, voting rights and dividends. Dating to the mid-1980’s, multiple-class funds have a flexible capital structure that permits the fund to make its shares available through multiple distribution channels and to provide different services to various types of shareholders that have differing needs for services. These multiple-class arrangements are much more efficient than the alternative of setting up “clone funds” with similar investment strategies but different distribution or shareholder-servicing arrangements.

Yet another innovative structure, now well-established, is the so-called master-feeder structure. A master-feeder structure consists of a partnership that holds a portfolio of securities and whose partners are various mutual funds (or other pooled investment vehicles). Like the multiple-class structure, the master-feeder structure provides efficiencies associated with having a single portfolio and the flexibility of offering investors different choices as to the means by which they can invest in that portfolio.

In addition to new fund structures, there has also been an increase in the variety and sophistication of investment styles. Back in the early days, mutual funds invested almost exclusively in stocks and bonds of U.S. companies. Today, investors demand a much broader array of choices in terms of risk/return profiles and asset classes. The fund industry has responded by offering funds that reflect different investment outlooks and perspectives.

Other developments that have contributed to the need to modernize the tax rules governing RICs include:

  • FASB Interpretation No. 48, Accounting for Uncertainty in Tax Positions. -- Commonly referred to as FIN 48, this accounting guidance requires entities with audited financial statements, including RICs, to evaluate their uncertain tax positions pursuant to a prescribed methodology and to post appropriate reserves. Given the lack of guidance as to numerous aspects of the tax rules applicable to RICs, FIN 48 has intensified the need for legislative clarification.
  • Information Reporting. -- Congress recently expanded the information reporting obligations of RICs by requiring that they report basis information to shareholders.  The requirements of the new reporting system put significant pressure on certain substantive rules, including rules that can result in retroactive basis adjustments as a consequence of events that may occur after a fund has already sent the shareholder basis information on a Form 1099-B.
  • Industry Experience with the Calendar-Year Distribution Requirements. -- In the 24 years since Congress added the calendar-year distribution requirements contained in Code section 4982, the fund industry has had significant experience with the intricacies of coordinating that regime with the long-standing rules of Subchapter M. The industry has made repeated requests of the Internal Revenue Service and Treasury Department to exercise their regulatory authority to address some of the problems, but a lack of resources has limited their capacity to issue guidance. In addition, certain “glitches” in the existing rules require a legislative solution.
  • Updates in the Statutory Rules Applicable to Real Estate Investment Trusts (“REITs”). -- Like RICs, REITs are subject to the rules of Subchapter M of the Code. The REIT rules in Subchapter M were modeled after the RIC rules and in most respects the rules closely parallel each other. In recent years, Congress has modernized the REIT rules on numerous occasions, including in 1997, 1999 and 2004. While some of the updates are peculiar to the nature of REIT investments, several of the changes should also be made applicable to RICs.

III. Illustrative Provisions in the Bill

Given the extremely technical nature of the provisions in the Bill, I will not attempt to describe all of them today. I would, however, like to highlight three illustrative provisions.

First, the Bill would amend certain technical rules that do not operate properly in a fund of funds structure. The existing rules contemplate a fund investing directly in stocks, bonds and related investments. For example, in order to pass through tax-exempt interest to shareholders, a fund must have at least 50 percent of its assets invested in municipal bonds. Similarly, to pass through foreign tax credits, a fund must have at least 50 percent of its assets in foreign securities. Because a fund of funds does not invest directly in underlying municipal bonds or foreign securities, but rather in lower-tier funds that hold these assets, the investor in a fund of funds structure loses the benefit of these flow-through provisions. The Bill would correct this defect.

Second, the Bill would provide relief for inadvertent failures of the RIC qualification tests. Under current law, if a RIC fails the qualification test relating to asset diversification or gross income, the RIC and its shareholders lose the benefits of Subchapter M. In 2004, Congress amended the qualification rules for REITs to provide a lesser sanction when a REIT inadvertently fails one of the REIT gross income or asset tests. The Bill would amend the RIC rules to include a savings provision modeled on these REIT precedents.

A third provision in the Bill would amend one of the current law provisions impacting a RIC’s ability to invest in gold and other commodities. Many financial advisors believe that commodities can be a useful hedge against inflation and therefore an important part of a diversified investment portfolio. In order to offer investors the ability to include commodities, such as gold, as part of their overall investments, a number of RICs gain exposure to commodities indirectly through investments such as structured notes. In recent years, the IRS has issued over 30 private letter rulings approving RIC investments in commodities through such indirect means. The Bill provides that income from commodities would be qualifying income for RICs. This change would facilitate the ability of investors who wish to include gold or other commodities as part of their portfolios to do so while also receiving the benefits of investor protection and transparency associated with investing through mutual funds and other investment companies regulated under the 1940 Act.

In closing, I would like to note that substantial effort has been made to keep the proposals non-controversial and to minimize the revenue impact of the Bill. We understand that the Bill has been scored as losing less than $190 million over 10 years. Given the size of the industry, it is remarkable that the Bill makes so many and varied improvements and yet has such minimal revenue effect.