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May 10, 1989
TO: TAX COMMITTEE NO. 6-89
ACCOUNTING/TREASURERS COMMITTEE NO. 20-89
CLOSED-END FUND COMMITTEE NO. 15-89
RE: INSTITUTE STATEMENT ON CAPITAL GAIN PROPOSALS
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Attached is the Institute's statement to the House Ways and
Means Committee concerning the President's capital gain proposal.
The statement addresses special problems that would be created
for regulated investment companies (RICs) and their shareholders
should Congress enact without modification either (1) the
President's proposal to lower to 15 percent the maximum capital
gain tax rate on qualified assets held by individuals for the
long-term capital gain holding period, which would be lengthened
to two years in 1993 and to three years in 1995, (2) any proposal
to provide three or more (multiple tier) holding periods for
capital assets, or (3) any proposal to index the basis of certain
capital assets.
1. The President's Proposal
The President's proposal contemplates that a RIC's
individual shareholders will be entitled to the 15 percent
capital gains tax rate on long-term capital gains realized by the
RIC and flowed through to its shareholders. One problem created
by the President's proposal for RIC shareholders compared to
direct investors is that lengthening the holding period for long-
term capital gain treatment would further diminish the ability of
RIC shareholders to offset unrelated capital losses against
capital gains realized by the RIC. Whereas under current law
only capital gains realized on assets held by the RIC for one
year or less are treated as short-term and denied flow through
treatment to RIC shareholders, the President's proposal would
treat as short-term capital gains those gains realized during the
first three years that an asset is held by the RIC and would,
consequently, deny RIC shareholders the opportunity they
presently have to offset unrelated capital losses from assets
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held for between one and three years against capital gains
realized on assets held by the RIC for between one and three
years. For this reason, the Institute believes that if the
President's proposal is enacted, RICs should be permitted to flow
through to their shareholders gains which may be designated in
accordance with the holding period from which they are derived.
2. Multiple Tier Capital Gain Proposals
Similarly, because RICs are currently able to flow through
to shareholders only those capital gains realized from one
holding period category (the long-term category), proposals to
increase the number of capital gain holding periods from two to
three or more would disadvantage RIC shareholders compared to
direct investors unless, as the Institute has recommended, RICs
are permitted to flow through to their shareholders gains which
may be designated in accordance with the holding period category
(be it long-term, middle-term, or short-term) from which they are
derived. The statement also notes that multiple tier capital
gain holding period proposals would create the need for "stacking
rules" to net losses from one holding period category against
gains from another category. Illustrations are given regarding
how these stacking rules could be developed.
3. Indexing Proposals
The indexing proposals currently before Congress would
provide generally for indexing the basis of corporate stock, but
not of debt obligations. Two types of indexing would apply to
RICs and their shareholders. First, the RIC itself would index
certain assets in its portfolio. Second, RIC shareholders would
index the basis of their RIC stock, which would be treated as an
"indexed asset," i.e., an asset eligible for indexing, for any
calendar month in the same ratio as the RIC's assets at month-end
which are indexed assets bears to the value of all of the RIC's
assets at month-end (the "indexed asset calculation"). This
second type of indexing, while critical to the fairness of any
indexing proposal, would require detailed recordkeeping and
burdensome computations.
The Institute's statement describes in detail the complex
computations that would be required under the indexing proposals
to determine the extent to which RIC stock would be treated as an
"indexed asset" eligible for indexing. In general, these
computations would be necessary unless a RIC were invested almost
exclusively in either corporate stock, in which case the RIC
stock would be treated as a fully (100 percent) indexed asset, or
in debt obligations, in which case the RIC stock would not be
treated as an indexed asset. The statement suggests modifying
the manner in which RIC stock is determined to be an indexed
asset to limit the computations that would be required.
Specifically, the Institute has proposed that (1) determinations
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of the extent to which RIC stock is to be treated as an indexed
asset would be made quarterly rather than monthly and (2) the
safe harbor provision: (a) treat the ratio of indexed assets to
all assets as being 100 percent if 80 percent or more of the
RIC's portfolio is in indexed assets, (b) treat the ratio as
being 50 percent if between 20 and 80 percent of the RIC's
portfolio is in indexed assets, and (c) treat the ratio as being
zero if 20 percent or less of the RIC's portfolio is in indexed
assets.
We will keep you informed of developments.
Keith D. Lawson
Assistant General Counsel
Attachment