New Tax Guidance Would Simplify Rules for Shareholders of Institutional Money Market Funds

by K&L Gates LLP
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On July 23, 2014, the Securities and Exchange Commission (SEC) adopted final rules governing the structure and operation of money market funds (SEC MMF Reform Rules). See our client alert entitled “SEC Adopts Floating-NAV and Liquidity Fees/Redemption Gates Rules for Money Funds” dated July 25, 2014. The SEC MMF Reform Rules will become effective 60 days after their publication in the Federal Register. This client alert discusses rules the U.S. Treasury Department (Treasury) and the Internal Revenue Service (IRS) have adopted or proposed to deal with the tax treatment of money market funds subject to the SEC MMF Reform Rules.

Floating-NAV Money Market Funds will not be subject to the wash sale rules.

Under the wash sale rules, a taxpayer may not recognize loss realized on the sale of stock or securities if the taxpayer purchases substantially identical stock or securities within 30 days before or after the sale. The taxpayer generally retains its old basis in the acquired stock or securities in order to preserve the loss. Because money market funds have historically sought to maintain a stable (typically at $1.00) net asset value per share (NAV), redemptions of money market fund shares have not been subject to the wash sale rules because, with a constant share price, redeeming shareholders could not recognize a loss.

The SEC MMF Reform Rules will require non-government institutional (i.e., not retail) money market funds, including institutional tax-exempt money market funds, to price their shares using the market values of portfolio securities (rather than the currently permitted amortized cost and/or penny rounding methods) and to calculate their NAVs to the nearest 1% or four decimal points. The share prices of funds subject to the SEC MMF Reform Rules thus are expected to “float.” A redemption of shares in a money market fund that has a floating NAV (Floating-NAV MMF) thus could produce a loss and potentially implicate the wash sale rules. Revenue Procedure 2014-45, released on the same day as the SEC MMF Reform Rules, however, provides that a Floating-NAV MMF will not be subject to the wash sale rules, effective for redemptions of shares on or after the effective date of the SEC MMF Reform Rules.

Under Revenue Procedure 2014-45, a taxpayer will be permitted to recognize loss on the sale of Floating-NAV MMF shares even if the taxpayer purchases shares in the same Floating-NAV MMF within the 30-day wash sale period. (Such purchases are quite common, particularly if a shareholder elects to reinvest dividends.) To qualify for this exception, the share issuer must be regulated as a money market fund under Rule 2a-7 under the Investment Company Act of 1940, hold itself out to investors as a money market fund, and be a Floating-NAV MMF. The Revenue Procedure is more permissive than the approach proposed last year in an IRS notice when the SEC proposed the money market fund rule amendments: the exception in the earlier notice only would have applied if redemptions did not exceed a de minimis threshold.

The IRS justified the approach taken in the Revenue Procedure based on the understanding that the share prices of Floating-NAV MMFs will be relatively stable and that monitoring Floating-NAV MMF transactions for wash sales would be unreasonably burdensome for taxpayers. In the Revenue Procedure, the IRS did not indicate how it would treat Floating-NAV MMFs for any other purpose. However, the preamble to the proposed Treasury regulations discussed below makes clear that any loss realized on the redemption of a stable-value money market fund (for example, because of a liquidity fee that is treated as a reduction in the redemption proceeds) will be subject to the wash sale rules.

Taxpayers may elect to account for dispositions of Floating-NAV MMF shares on an aggregate basis.

Treasury and the IRS also issued proposed income tax regulations that will greatly simplify the calculation of gain and loss realized on redemptions of Floating-NAV MMF shares. Under the proposed “NAV method,” a taxpayer generally may calculate gain or loss based on the change in the value of its Floating-NAV MMF shares between the beginning and end of a “computation period.” The computation period may be the taxpayer’s taxable year or a shorter period, but all computation periods must be approximately equal in length. The character of the realized gain or loss will depend on the character of the underlying Floating-NAV MMF shares in the taxpayer’s hands, but any net capital gain or loss will be treated as short-term. Dividends paid by Floating-NAV MMFs will be subject to federal income taxation and information reporting in the same way as all other dividends.

A taxpayer may elect to use the NAV method simply by employing it in the taxpayer’s federal income tax return for the first taxable year in which the taxpayer holds shares of a Floating-NAV MMF.  The NAV method is considered an accounting method for tax purposes and, if elected, must be applied to all Floating-NAV MMF shares owned by a taxpayer. Once that method is elected, IRS approval is required to cease using it.

Although the proposed regulations regarding the NAV method will not apply until taxable years beginning on or after the taxable year in which they are finalized, the regulations expressly permit taxpayers to rely on them for taxable years ending on or after their publication date. Treasury and the IRS gave no indication of when these regulations might be finalized.

Treasury and the IRS also requested comments on whether the NAV method should also be available for shareholders in a stable-value money market fund, given that redeeming shareholders in such a fund may also recognize gain or loss if the fund charges a liquidity fee as permitted under the SEC MMF Reform Rules.

Like other money market funds, Floating-NAV MMFs will not need to issue Form 1099 to redeeming shareholders.

Floating-NAV MMFs, like money market funds generally, also will be exempt from the information-reporting requirements applicable to brokers, transfer agents, and certain issuers of securities (including mutual funds) on Form 1099. The existing exemption for money market funds that have a stable NAV is premised on the fact that a redeeming money market fund shareholder will not recognize gain or loss because the share value is always the same. Since the NAV of Floating-NAV MMF shares will vary and, thus, redemptions of those shares may produce gain or loss, there was some concern that those transactions would be subject to these information-reporting requirements.

The proposed regulations confirm that the reporting agents described above—including the Floating-NAV MMFs themselves—are not required to issue Forms 1099 with respect to transactions involving Floating-NAV MMF shares. Many shareholders of Floating-NAV MMFs would not receive Forms 1099 anyway because they are exempt recipients under the regulations; these include corporations, tax-exempt entities (including pension funds and individual retirement accounts), governmental entities, financial institutions, and other regulated investment companies.

Taxpayers and persons that would otherwise be required to issue Forms 1099 with respect to securities transactions may rely on these proposed regulations on information reporting for calendar years beginning prior to the date on which they are finalized.

Note that the proposed regulations affect only the information-reporting requirements and do not alter the substantive tax rules that apply to redemptions. Thus, a shareholder redeeming Floating-NAV MMF shares must still recognize and pay tax on gain realized in a redemption.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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