Guest Contributor: Stevie D. Conlon, Senior Director and Tax Counsel, Wolters Kluwer Financial Services
The author thanks John Kareken and Anna Vayser of Wolters Kluwer Financial Services for their assistance.
There were several important announcements made last month by the IRS that provide critical income tax relief for investments in money market funds under new Securities and Exchange Commission (SEC) rules.
On July 23, 2014, the IRS issued proposed regulations that expand the existing exclusion from gross proceeds reporting and cost basis reporting on Form 1099-B for “floating NAV” money market funds (MMFs) under new SEC rules for certain investment companies.
The IRS also issued proposed regulations providing a taxpayer elective simplified net gain/loss method of reporting gains and losses from floating NAV MMFs. Under the elective reporting method, because no loss is determined for any particular redemption of shares, the IRS has stated that the wash sale rule does not apply. For taxpayers that do not elect the simplified reporting method, the IRS also issued a revenue procedure providing that the wash sale rule does not apply to sales of floating NAV MMF shares. Although this guidance was issued in proposed rather than final form, it is effective immediately.
On July 24, 2014, the SEC voted, as noted in a Treasury Department fact sheet of the same date, “to require certain money market funds (MMFs) to price shares in a manner that more accurately reflects the market value of the funds’ underlying portfolios.” These certain MMFs can no longer rely on special SEC exemptions that allowed them to maintain a stable net asset value (NAV). For these funds, the share price will float and the funds will be known as floating-NAV MMFs.
The stable share NAV of money market funds, typically $1 per share, came under pressure in the recent economic crisis, as fund outflows demonstrated the real risk of funds breaking the buck, or being unable to maintain the stable $1 per share NAV.
SEC Rule 2a-7 contains detailed rules for MMFs and the type and quality of assets which the fund is permitted to hold. One requirement is for the fund’s use of the amortized cost method of valuation that calculates NAV by valuing the fund’s portfolio securities at their acquisition cost “as adjusted for amortization of premium or accretion of discount rather than at their value based on current market factors.” Together with this requirement, Rule 2a-7 requires the use of the penny rounding method of pricing – “the method of computing an investment company’s price per share for purposes of distribution, redemption and repurchase whereby the current net asset value per share is rounded to the nearest one percent.” These requirements permit the fund to maintain a stable net asset value, or stable price, per share.
The amendments to SEC Rule 2a-7 require certain funds to use market valuation of their portfolio securities for distribution, redemption and repurchase, thus causing the share price to float rather than remain stable at the typical $1.
With a floating NAV, institutional prime money market funds (including institutional municipal money market funds) are required to value their portfolio securities using market-based factors and sell and redeem shares based on a floating NAV. These funds no longer will be allowed to use the special pricing and valuation conventions that currently permit them to maintain a constant share price of $1.00. With liquidity fees and redemption gates, money market fund boards have the ability to impose fees and gates during periods of stress. The final rules also include enhanced diversification, disclosure and stress testing requirements, as well as updated reporting by money market funds and private funds that operate like money market funds.
The final rules provide a two-year transition period to enable both funds and investors time to fully adjust their systems, operations and investing practices.
Treasury and IRS Guidance
In a coordinated action with the SEC last month, the Treasury and IRS issued proposed guidance in the form of proposed regulations (REG-107012-14, published in July 28 Federal Register) that provide a “simplified, aggregate annual method of tax accounting for these gains and losses, simplifying the tax treatment and promoting compliance.” The Treasury Department fact sheet notes that the guidance is “proposed rather than final to provide the public an opportunity for comment. Nevertheless, shareholders in floating NAV MMFs can now rely on these proposed regulations to begin to use the simplified method.”
The proposed IRS rules permit a simplified method of accounting (the NAV method) allowing shareholders to aggregate transactions and measure net gain/ loss, using information routinely provided by the funds. Net gain/loss is to be determined by the increase or decrease in share value for a certain period, such as the tax year minus the net investment in the shares, i.e. purchases minus sales for the period.
Wash sale relief
Under IRS Code Sec. 1091, a wash sale occurs when a shareholder sells a security at a loss, and within 30 days before or after the sale, acquires a substantially identical stock or security. The new floating rate funds would cause a shareholder to run afoul of the wash sale rule because the floating rate would generate losses on sales of shares that would be disallowed and cause enormous complications for taxpayers making many purchases and sales of money market shares, including, as the IRS notes, purchases made as a result of sweep arrangements and reinvestments of monthly distributions. As the new IRS proposed rules and a new revenue procedure explain, the wash sale rule would not be triggered by losses that are netted by using the simplified NAV method of reporting. To address the wash sale situation for those that do not use the NAV method, a new and final revenue procedure, Rev. Proc. 2014-45, was issued by the Treasury and IRS. It provides that a redemption of a money market fund share of a 1940 Act investment company shall not be treated as part of a wash sale under these circumstances: (1) The investment company is regulated as an MMF under Rule 2a-7 and holds itself out to investors as an MMF; (2) At the time of the redemption, the investment company is a floating-NAV MMF.
The proposed IRS rules exempt the new floating-NAV funds from gross proceeds, basis and holding period reporting under IRS Code Sec. 6045. Stable value money market funds were excluded from such reporting under Treas. Reg. 1.6045-1(c)(3)(vi). This rule states that “no return of information is required with respect to a sale of an interest in a regulated investment company that can hold itself out as a money market fund under Rule 2a-7 under the Investment Company Act of 1940 that computes its current price per share for purposes of distributions, redemptions, and purchases so as to stabilize the price per share at a constant amount that approximates its issue price or the price at which it was originally sold to the public”. The proposed rules eliminate the reference to stable value funds so that the exemption applies to all Rule 2a-7 funds.
The revenue procedure wash sale relief for redemptions is effective for redemption made on or after the effective date of the SEC rules discussed above, expected 60 days after Federal Register publication. The proposed regulations on the NAV method, although not final, can be relied on by shareholders of floating-NAV money market funds for taxable years ending on or after July 28, 2014 and beginning before publication of final regulations.
Stevie Conlon will be a featured speaker at the upcoming CAPCon New York conference on October 16, 2014. Stevie will be speaking on the “New Corporate Action Burdens Under FATCA” with Dana Pasricha, Vice President at Brown Brothers Harriman.
They will be discussing how the new Foreign Account Tax Compliance Act (FATCA) rules require tax analysis of corporate actions affecting investments in debt securities that can affect U.S. tax obligations that firms must withhold on payments to clients. The new rules for grandfathered FATCA debt obligations and determining when corporate actions adversely impact favored grandfathered status will be explained. The operational and compliance challenges under these new requirements will also be discussed.