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The No-Muss, No-Fuss Modernization Act

With implementation of the Dodd-Frank Wall Street Reform Act about to shower hundreds of new rules on capital markets, it's easy for other legislation to take on a cloak of invisibility.

Such is the case of the Regulated Investment Company Modernization Act of 2010, which, according to the accounting firm KPMG, "ushers in a new era for regulated investment companies [RICs or mutual funds] and their shareholders by reducing tax uncertainty, further aligning the taxation of RIC shareholders with that of direct investors, and providing greater flexibility in investment strategies ."

The new rules generally apply to tax years beginning after Dec. 22 of this year or distributions made in taxable years beginning after Dec. 22.

Significant changes include new rules that allow funds of funds to pass through exempt-interest dividends and foreign tax credits to shareholders, allow funds to make use of unlimited capital loss carryovers and, most notably, repeal a ban on so-called preferential dividends. Where a RIC, aka mutual fund, before had to distribute dividends evenly among all shareholders, now it can distribute dividends on a non-pro rata basis, without incurring tax penalties.

These penalties are no small matter. Investment companies seek regulated status so they can pass the taxes on capital gains, dividends, or interest payments onto the clients or individual investors and not incur them directly.


Avoiding 'Foot Faults'


The act helps mutual funds avoid penalties from what Investment Company Institute Senior Counsel for Tax Law Keith Lawson calls "foot faults"-unintended and inadvertent failures to meet various requirements for qualifying to be a registered investment company.

To be considered a regulated investment company, for instance, a fund must derive at least 90% of its gross income from dividends, interest and other payments related to its business in investing in stocks, currencies and securities, maintain at least 50% of its assets in cash and highly liquid securities and allow no more than 25% of the value of its assets to be invested in securities from any single issuer.

Indeed, Lawson said from an operational standpoint, the 17 or so major changes that constitute the modernization of the registered investment company tax law aren't that big a deal. Most are easily handled by updating parameters governing and rules kept in mutual funds' information systems.

"From the perspective of the funds, the big issue isn't so much the changes to the computer programs," he said. "A big benefit comes from the various savings provisions, in terms of issues that previously were of concern to compliance officers, where you previously would have had a qualification issue."

In the past, if a large investment fund with $1 billion of income and gains failed an asset diversification test or the gross income test, a $350 million tax liability could be incurred, accounting firm PricewaterhouseCoopers noted, in its first assessment of the impact of the modernization act.

That kind of penalty would be incurred "even if the failure is de minimis or inadvertent." Now, so-called "savings provisions" of the 2010 act allow a fund to preserve its status as a registered investment company, as long as it follows proscribed rules and pays a tax, which is deductible, according to PwC.

The new act, in effect, will have "de minimis" impact on mutual funds' operations. Some provisions will require some system changes, such as tax-loss carryovers.

But the changes are relatively straightforward, dealing with whether the losses are short-term or long-term losses, which losses get used first against taxation and how different gains and losses are netted out.

"I'm not sure that there's anything particularly fascinating about the operational aspects of RIC modernization,'' Lawson said.

The modernization, however, could impact the big systems change project of the year for mutual fund companies: preparing for the new cost-basis reporting rules of the Internal Revenue Service.

Mutual funds, including closed-end funds and stocks and REITs in dividend reinvestment plans will be covered by the new rules, if purchased on or after Jan. 1, 2012, for instance. But the details of reporting the cost basis of securities and other financial instruments are complex.

Mandatory cost-basis reporting for mutual funds and dividend reinvestment plans "really touches everything in the organization," according to Ellen Bocina, vice president of product development at Fidelity Investments.


Fewer Forms


RIC modernization adds to the complexity-but may reduce some of the pressure at the same time.

The act will reduce the number of amended Forms 1099 that funds will be required to be sent to shareholders, in light of the new cost-basis reporting requirements, according to Karen Gibian, associate counsel at ICI .

For instance, when funds make payments back to shareholders, the return of capital used to require amending of Forms 1099, in cases when there was a mismatch of a fund's fiscal year and the IRS' calendar year for tax reporting.