The U.S. Internal Revenue Service (IRS) has proposed a new Revenue Procedure (Proposed Revenue Procedure) regarding the application of the wash sale rules under Section 1091 of the U.S. Internal Revenue Code (Code) to floating net asset value (NAV) money market mutual funds (money funds).1 The IRS issued the Proposed Revenue Procedure in order to mitigate certain tax compliance burdens that the U.S. Securities and Exchange Commission (SEC) outlined in its proposal to require “institutional” money funds to operate with a floating NAV (SEC Proposal).2
As discussed in more detail in this DechertOnPoint, the Proposed Revenue Procedure provides that, if a shareholder realizes a loss upon the redemption of floating NAV money fund shares and the amount of the loss is de minimis (as defined in the Proposed Revenue Procedure), the IRS would not treat the loss as being subject to the “wash sale” rules.
Money funds are currently able to maintain a stable NAV per share of $1.003 by using the amortized cost method of valuation4 and/or the penny-rounding method of pricing.5 These methods simplify tax compliance for shareholders. This is because purchases and sales of money fund shares at a stable $1.00 share price generate no gains or losses, and, therefore, money fund shareholders generally do not need to track the timing and price of purchases and sales of shares in order to determine the amounts of taxable gains and losses realized.
On June 5, 2013, the SEC issued for public comment the SEC Proposal, which proposed sweeping amendments to Rule 2a-7 under the Investment Company Act of 1940 and other rules relating to money funds. The SEC Proposal included two key alternatives – (i) requiring “institutional” money funds to operate with a floating NAV, rounded to the fourth decimal place (e.g., $1.0000) (Alternative 1) or (ii) requiring money funds (other than government money funds) to impose a 2% liquidity fee during times of stress and allowing them temporarily to suspend redemptions using “redemption gates” during such times.
Under Alternative 1, money funds (other than “government” and “retail” money funds, as defined below)6 would be required to operate with a floating NAV, calculating their market-based NAV per share to the nearest basis point. If adopted, Alternative 1 would require an institutional money fund to calculate its share price to the fourth decimal place if it prices its shares initially at $1.00 per share using “basis point” rounding (e.g., $1.0000).
“Government” and “retail” money funds would be exempt from the requirement to convert to a floating NAV and could continue to use the penny-rounding method to price their shares, although the use of the amortized cost method of valuation would be prohibited (except under certain circumstances). Under the SEC Proposal, government money funds would be defined as money funds that maintain at least 80 percent of their total assets in cash, U.S. government securities or repurchase agreements that are “collateralized fully” (as defined in Rule 2a-7). Retail money funds would be defined as those that do not permit a shareholder to redeem more than $1 million of fund shares on any one business day.
The SEC Proposal acknowledged that, under Alternative 1, shareholders in a floating NAV money fund would experience gains and losses in connection with purchases and sales of money fund shares. Taxable shareholders in floating NAV money funds would need to determine the amounts of such gains and losses and would generally owe taxes on gains and potentially derive benefits from losses.
The SEC Proposal also acknowledged and discussed the difficulties that would result from the application of the “wash sale” rules to redemptions of shares in floating NAV money funds. The wash sale rules in Section 1091 of the Code disallow losses on the sale or other disposition of shares of stocks or securities if “substantially identical” stocks or securities are acquired within 30 days before or after the sale. Under these circumstances, the disallowed loss would generally be added to the basis of the related acquired shares, subject to certain adjustments, which effectively postpones the deduction of losses until the shareholder recognizes gains or losses on those acquired shares. Because money fund investors typically reinvest dividends (which results in the purchase of additional shares) and may also make frequent additional purchases, if the wash sale rules applied to redemptions of floating NAV money fund shares, then losses on virtually all redemptions could be disallowed in whole or in part until an investor redeems the related acquired shares (or longer, if the redemption of the related acquired shares is also a wash sale).
The Proposed Revenue Procedure
In connection with the SEC Proposal, the IRS issued the Proposed Revenue Procedure to address the concerns outlined by the SEC regarding the application of the wash sale rules to a floating NAV money fund. The Proposed Revenue Procedure states that floating NAV money fund shares, despite their ability to fluctuate, would have “relatively stable values,” and, therefore, do not give rise to the concerns that the wash sale rules are designed to address.
Accordingly, under the Proposed Revenue Procedure, if a shareholder realizes a loss upon the redemption of floating NAV money fund shares and the amount of the loss is de minimis, the IRS would not treat the loss on the redemption as subject to the wash sale rules under Section 1091 of the Code. For these purposes, a de minimis loss would be a loss realized upon a redemption of a floating NAV money fund share, the amount of which (expressed as a positive number) is not more than one-half of 1% (i.e., 0.5%) of the shareholder’s basis in the share.
Notwithstanding the IRS’s efforts to exempt certain de minimis transactions in money fund shares from the wash sale rules, the SEC noted in the SEC Proposal that “money market funds would still incur operational costs to establish systems with the capability of identifying wash sale transactions, assessing whether they meet the de minimis criterion, and adjusting shareholder basis as needed when they do not.” These issues are not addressed by the Proposed Revenue Procedure.
In addition, although the Proposed Revenue Procedure addresses the application of the wash sale rules to redemptions of shares in floating NAV money fund shares under the SEC Proposal, it does not address other complexities that would result if the SEC Proposal is adopted. In such a case, shareholders would be required to track the timing and price of purchases and redemptions of money fund shares to determine the amount of taxable gains and losses realized. Although these gains and losses would normally be small (e.g., a redemption of 100,000 shares when there is a one basis point drop in a money fund’s NAV after purchase would result in a loss of $10), it would be extremely burdensome for shareholders to keep track of such purchases and redemptions. Because the SEC Proposal would require basis point (0.0001) rounding for shares of floating NAV money funds, many, and possibly most, redemptions could result in gains and losses. The frequency of purchases (including reinvested dividends) in varying amounts and at different NAVs would make it difficult to determine the cost of shares being redeemed. It should also be noted that differing methods could potentially be chosen by each shareholder to identify the cost of the particular shares being redeemed when there were purchases at different times (e.g., FIFO, LIFO, average cost and specific identification).
Additional complexities would be caused by the fact that gains and losses would be capital gains and losses, which may be either short-term or long-term depending on the holding period of redeemed shares. Various netting rules would apply to such gains (including capital gains and losses from other investments). Further capital losses can generally only offset capital gains, and rules for capital loss carryovers can result in additional complexities.
Although the SEC Proposal appears to contemplate that the money funds could determine and report gains and losses, any such requirements would be very costly and burdensome. Current information reporting rules do not apply to redemptions of money fund shares. The cost basis information reporting rules for registered investment companies also generally apply only to sales of shares acquired after January 1, 2012. Further, Form 1099 reporting does not apply to certain exempt recipients (including corporations taxed under Subchapter C of the Code). Any requirement to expand information reporting requirements to floating NAV money funds would require such funds and any relevant intermediaries to implement systems, processing and reporting changes, which would cause substantial additional costs. Increased complexity would also arise in light of the various potential methods for lot selection by investors with respect to redeemed shares.
The Proposed Revenue Procedure explicitly references Alternative 1 of the SEC Proposal and was drafted on the assumption that Alternative 1 would be adopted as proposed. To the extent Alternative 1 is not adopted in substantially the same form as proposed, the Proposed Revenue Procedure may not be adopted or may be adopted in a materially modified form.
The Proposed Revenue Procedure demonstrates a coordinated effort between the SEC and the IRS in connection with potential money fund reform. However, while the IRS is seeking to mitigate the tax compliance burdens associated with the application of the wash sale rules to a floating NAV money fund, there are various other potential tax concerns that would arise if Alternative 1 of the SEC Proposal is adopted as proposed. Comments on the Proposed Revenue Procedure are due by October 28, 2013.