This tax season, the regulatory fallout from the mutual fund scandals will leave tax practitioners treading in uncharted territory.

For the first time, they will have to consider the tax implications of over $3.5 billion of settlement fines, penalties and expenses relating to the recent mutual fund scandals.

Those scandals blew open when a former hedge fund executive, Noreen Harrington, called the New York State Attorney General's Office during the summer of 2003 and disclosed the trading activities of her former employer, Canary Capital, that ultimately harmed mutual fund investors.

Initially, Harrington's disclosure seemed indistinguishable from a flood of calls that flowed into the AG's office after New York State Attorney General Eliot Spitzer established himself as a protector of investor rights when he wrangled the largest settlement out of Wall Street firms for biased investment research.

Nevertheless, the call proved potent, based on its impact on the $7.4 trillion mutual fund industry - which had a 70-year-old reputation for being a safe harbor for ordinary investors.

Mutual fund companies were subpoenaed for information by the Securities and Exchange Commission, various state attorneys general and state regulators after Spitzer's announcement in September 2003 that he had reached a settlement with Canary Capital.

Canary Capital was a hedge fund that profited handsomely from the rapid trading of mutual fund shares at the expense of investors. In secret deals with four big-name mutual funds, Canary Capital, in exchange for asset deposits benefiting the mutual fund investment advisor - which is compensated by the fund based on an asset-based management fee - obtained lists of the daily portfolio of holdings from the investment advisor. This allowed Canary to arbitrage - by taking long and synthetic short positions - market changes that impacted the share's net asset value after the 4 p.m. market close.

A year after Spitzer's announcement, U.S. regulators continue to find widespread market-timing abuses in the industry. The abuses are not only in mutual funds, but also in mutual funds marketed as subaccounts in variable annuity contracts.

In December, the SEC announced that it had recorded market-timing activity in 40 out of 88 subpoenaed mutual companies, and according to Don Cassidy, senior research analyst at Lipper Inc., "We believe more are yet to come, since out of roughly 11,300 equity funds and classes, some 389 equity funds and classes in fiscal 2002 showed profiles typical of churn: redemptions at over 250 percent of fund assets and redemptions also in close alignment with sales. Sixty funds had redemptions exceeding 1,200 percent, meaning complete money turnover on a monthly basis. The average redemption percentage was 500 percent for the 389 funds, contrasted with the industry average of 38 percent for equity funds."

Roughly two dozen mutual fund firms are implicated in market-timing abuses. The companies thus far represent 23.6 percent of mutual fund industry assets, or $1.648 trillion out of total assets of $6.971 trillion as of the end of August, according to Cassidy.

For the first time in 70 years, nearly a dozen companies have agreed to pay an aggregate $3 billion in settlements, including cash penalties, restitution to investors and reduced management fees. (See box below).

Fine & penalty payments

So who will bear the cost of these cash fines, penalties and restitution payments - the investment advisor or the mutual fund? It is becoming clear that insurance companies are not going to shoulder the cost, as they point to insurance policy language that excludes coverage for fines and penalties. And to what extent will these payments be tax deductible to the investment advisor or the mutual fund, or included in the income of the mutual fund shareholders? These are the types of questions that tax practitioners will have to address for the first time this tax season.

Generally, for federal income tax purposes, fines and penalties paid for violations of securities and other laws cannot be deducted. While market timing itself is not illegal, an investment advisor that assists a hedge fund to market-time the shares of its mutual fund might have violated federal or state securities laws for insider trading or after-hours trading. Furthermore, fraud fines and penalties paid for the purchase or sale of stock might have to be capitalized, because they have their origin in the stock transaction.

A tax practitioner might have to sift through various mutual fund settlements to sort out what percentage of the paid cash settlements apply to non-deductible fines, penalties or restitution payments. What is certain, however, according to James Hillman, senior vice president at Bank of New York's mutual fund domestic custody division, is that "cash fines or penalties and restitution payments would be the investment advisors' cost, and not the mutual funds'."

Restitution payments

Mutual fund shareholders are slated to receive about $860 million for restitution from their investment advisors. Unlike fines and penalties, for federal income tax purposes an investment advisor may be able to deduct restitution payments made to mutual fund shareholders, only if the restitution payment is compensatory, rather than punitive, in nature.

While the investment advisor might be able to shift this cost back to mutual funds in the form of increased management fees, under Spitzer's settlement pacts, to avoid the cost of shareholders cleaning up the industry, the attorney general has forced management fee rate cuts - in many cases set at 20 percent for five years. This was done to pressure advisors to lower fund fees across the industry and to limit the cost of the restitution payments that would be passed along to shareholders as an increase in management fees.

While this may be a relief to shareholders who were hurt by market-timing abuses allowed by their fund's investment advisors, most restitution payments to shareholders would be small, and made not as cash payments but as a direct deposit to the investor's mutual fund account. "The exact amount is going to vary by the size of the investor's account and how badly each fund was abused," said Cassidy.

As investors await the deposit of their restitution payments, their tax practitioners should prepare to answer questions regarding the tax treatment and characterization of restitution payments for their clients. Those clients may be either U.S. or foreign taxpayers who hold their mutual fund shares in taxable, tax-deferred or tax-exempt accounts.

Legal, insurance and administrative expenses

The fund-management companies are likely to absorb the fines and restitution payments stemming from the market-timing of mutual fund share abuse. Nevertheless, there are other costs, including insurance, legal and administrative expenses that may come out of fund assets and therefore out of the pockets of fund investors, all of which could easily total more than $1 billion a year.

For example, shareholders of the Strong funds may be obligated to indemnify its former chairman and founder, Richard Strong, for any losses, and also for legal expenses that he incurred in settling claims arising in suits for breach of his fiduciary duty to his investors.

It is commonplace in many corporations for key executives and directors to seek protection against liability for the improper conduct of their business duties by indemnity agreements, reimbursement bylaws, or business liability insurance. Direct payments of such liabilities to third parties by the corporation are typically tax deductible, absent an agreement that the employee will reimburse the corporation.

After building Strong Financial Corp. from nearly nothing into one of the nation's largest independent money managers over the course of three decades, Richard Strong abruptly resigned his position with the company in November, after being accused of improperly market-timing Strong funds for his personal accounts, as well as those of friends and family, to the tune of as much as $600,000 in profits attained at the expense of his mutual fund shareholders' accounts.

His investors included Oregon and Wisconsin's college education savings programs. Strong agreed to a $60 million fine and $115 million in related penalties to settle allegations that he made improper mutual fund trades.

What is clear is that the Internal Revenue Service allows as a business deduction any premiums paid by a corporation for group liability insurance indemnifying the corporation's officers for the expenses of defending lawsuits alleging misconduct in the officers' official capacities, under IRC 162. These payments also do not constitute gross income to the officers.

Since a mutual fund has a unique corporate structure, the deductibility of its expenses, as opposed to that of regular corporations, raises two additional tax issues that practitioners need to consider.

The first tax issue raised by a mutual fund's expense structure relates to the basic issue of the mutual fund-level or shareholder-level deductibility of the business expenses.

Mutual funds are generally in business to enhance the market value of a pool of securities and the value of their shareholders' interests in that pool. Expenses borne and related to the production of collectively shared income are deductible by the mutual fund as trade-or-business expenses under IRC 162.

Most of the expenses typically incurred by a mutual fund clearly relate to the management of its investment portfolio or its operations as an investment company, including registration fees, legal and accounting fees, custody fees, transfer agency fees, and other general administrative service fees, and are deductible as business expenses at the mutual fund level and not at the shareholder level. The shareholder level is subject to the 2 percent floor on miscellaneous itemized deductions under IRC 212.

The deductibility of a fund expense depends on whether it collectively enhances shareholder value, and relates to the production of collectively shared income. This raises an interesting question about the deductibility of legal fees as a business expense at the mutual fund level under 162 for Strong or for any other market timer who had a fiduciary duty to the shareholders of a market-timed fund. These legal fee payments may raise preferential dividend issues.

The preferential dividend problem is the second tax issue raised by a mutual fund's expense structure, which is implicated by the way in which a mutual fund preferentially allocates expenses among multiple classes of shares and waives or reimburses those expenses.

For example, when Strong Financial Corp. reimbursed the State of Wisconsin College Education Program board for $77,000 to cover its legal fees in the market-timing investigations for breach of its fiduciary duties, it might have constituted a waiver, in the sense that the reimbursement increased the total return available in respect of the fiduciary relationship between the investment advisor and the Wisconsin program.

The IRS recognized that amounts that an investment advisor must return to shareholders or amounts by which it must reduce its fee, in its capacity as a fiduciary to those shareholders, do not affect the fees imposed at the mutual fund level, and therefore the deductibility of amounts paid to those persons as shareholders. However, such waivers may raise special preferential dividend issues that tax practitioners should be aware of.

Undoubtedly, the regulatory scrutiny of the mutual fund industry will also affect tax practitioners, who will have to address an array of new tax issues this season.

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