MUTUAL FUND REORGANIZATIONS

Presented byVito FrondaMurray Goldsmith

August 13, 2003

General Rule

• IRC Section 1001:• Except as otherwise

provided, gain or loss on the sale or exchange of property

shall be recognized….

Can a transaction qualify as an exception?

• Is it described in Section 368?o Will it have the requisite “continuity of shareholder

interest”?o Will it have the requisite “continuity of business

enterprise”?o Will it have the requisite business purpose?o Is it consistent overall with “carrying on the target’s

business in a modified corporate form”?

Section 368Types of Reorganizations

• A - Statutory Merger Under State Law• B - Stock for Stock Exchange• C - Stock for Assets (Whale Swallows Minnow)• D - Stock for Assets (Minnow Swallows Whale)• E - Recapitalization• F - Moving One Portfolio• G- Financial Distress

C’s

• Transfer by T to A of “substantially all” of T’s assets

• In exchange for voting stock of A

• Followed by complete liquidation of T

A

3

2

1

T

D’s • Like C’s, except• T’s shareholders must

have section 304 “control” of A immediately after,

• Voting shares not necessarily required, and

• Gain generally recognized by T to the extent transferred liabilities exceed basis

AT

3

2

1

F’s • Single corporate migration• “Mere change” in identity,

form, or place of organization

• 99% continuity of shareholders, assets, and liabilities

• Issue: other shareholder vote changes

• No assets requirement for A

T

2

1

A

Selected Issues • Throwbacks - Can a dividend paid by A

be treated as a throwback by T?• Post-October losses of T- usable by A or

gone forever? Subject to 382?• Intentionally failing reorg status to

recognize losses• Loss Carryovers

Existence of Reorganization Plan

A copy of the plan must be included as part of each party’s federal income tax return for the year of reorganization

Carryover Provisions

§ 381-384Limitation on use of carryover attributes from the acquired fund could apply.

Consequences of a Tax- Free Merger

• The acquired RIC will not recognize any gains or loss on the transfer of its assets to the acquiring RIC in exchange for stock of the acquiring RIC.

• Acquiring fund will use the carryover tax basis and holding period of the assets for the acquired RIC.

• Shareholders of the acquired RIC will not recognize any gain or loss upon the exchange of their shares in the acquired RIC for shares in the acquiring RIC.

Consequences of a Tax- Free Merger Continued

• Shareholders of the acquiring RIC are not impacted by the transaction

• Different accounting method used by the funds must be addressed for tax purposes.o Generally, change is made to the dominant method

of accounting, measured by the assets accounted for under each method.

Consequences of a Tax- Free Merger Continued

The utilization of loss carryforwards and built-in-losses are limited where a fund incurs a change in ownership. If either fund has built-in-gains at the date of the reorganization, additional limitations may apply.

Impact on Subchapter M Requirements -Acquired Fund

• The acquired RIC’s tax requirements must be considered for the final year even if it is a short year of less than 12 months.o 100% of ordinary income and net long-term gains

must be distributed in order to avoid any income and/or excise tax

Impact on Subchapter M Requirements - Acquired Fund Continued

• Qualifying income must be at least 90% of gross income, and

• Quarterly asset diversification tests must be met in the final quarter. It should be noted that the 30 day grace period for correcting discrepancies in the asset diversification tests may not be available in the final quarter.

CLCO limitations

Capital Loss Carryover Limitations in Merger Context

Content:• §381 Limitations• §382/383 Limitations• §384 Limitations

General Carryover Provisions (§381-384)

• Tax attributes carry over to successor corporations in the following transactions: ‘A’ Reorganizations ‘C” Reorganizations ‘Integrating D’ Reorganizations ‘F’ Reorganizations

General Carryover Provisions (§381-384) Continued

• §§ 381-383 limitations apply to acquired fund (for tax purposes, the smaller fund measured by net assets)

• §384 limitations could apply to either the acquired or acquiring fund

• While each of the limitations are calculated separately, they must be reviewed together to ensure that carryover attributes utilized by the acquiring fund are allowable under all applicable limitation provisions.

§381 Discussion

• § 381 allows the acquiring fund to utilize the acquired fund’s capital loss carryover to offset realized gains in the first taxable year ending after the merger.

• §381 applies only to the first fiscal year- end after the merger.

§381 Limitation Calculation

The use of the capital loss carryover in the first taxable year ending after the merger is limited to the following under §381:Acquiring fund’s net capital gain The number of days in the year(without regard to any short term after the date of mergercapital loss carryover) for the first X -----------------------------------------taxable year ending after the date The total number of days in of the merger taxable year.

Example #1 - §381

Fund A and Fund B - both calendar year end funds.Fund A (acquired fund) merged with Fund B (acquiring fund) on September 15, 1999.The net capital gains and losses of each fund are as follows:Fund A Fund BTaxable Year: 1997 $(1,000,000) $250,0001998 500,000 250,000Ending 9/15/99 (100,000) N/A1999 N/A 300,000--------------- --------------Total $ (600,000) $800,000

Example #1 - §381

Question: What is total capital loss carryover from Fund A which can possibly be used by Fund B?

Answer: Only $87,945 ($300,000 x 107/365) of Fund A’s $600,000 capital loss carryover may offset Fund B’s 1999 net capital gain. 107 days is calculated from 9/16/99 through 12/31/99. The remainder of the Fund A’s capital loss carryover may be utilized in future taxable years, subject to the §382/383/384 limitations.

§382 & 383 Discussion

• §382 deals primarily with NOLs and so called “net unrealized built-in gains and losses”. Also, §382 lays the framework for the computation of loss limitations for both NOLs and built-in gains/(losses).

• §383 deals with CLCO and makes reference to §382 in terms of how CLCO limitations should be computed (same as NOL limitation computation).

§382 & 383 Discussion Continued

• Limit the amount of taxable income against which pre-change losses (CLCO, built-in-unrealized losses, possibly POL) may be utilized. o Loss corporation - Exists when there is NOL (also applies

to capital loss) or unrealized built-in-loss for the tax year in which there is an ownership change.

o Equity Structure Shift (Ownership Change) - Occurs when the percentage of loss corporation owned by one or more shareholders has changed by more than 50%. For RICs, the fund with the ownership change will be the fund with smaller net assets at the merger date.

§382 Limitation Calculation

• § 382 limitation is computed by:

The value of the stock of the ownership change X The long-term taximmediately before the merger exempt rate

• Limitation computed only once, not annually• Unused limitation can carry over from year to

year.

Short Year §382 Limit Calculation

In the year of change, the § 382 limit is:

No. of days after merger throughAnnual § 382 limit x end of acquiring fund’s fiscal yearTotal number of days in acquiring fund’s fiscal year

§382 Unrealized built-in-gains/losses (“BIG” or “BIL”)

• Section 382 provides that limitation can also be affected by unrealized built-in capital gains or losses (i.e., the difference between the fair market value of the fund’s assets and their tax basis immediately before the reorganization).

• In general, built-in gains can have the effect of increasing loss limitations (meaning RIC would have more of its pre-ownership change losses to off-set post-change gains) while built-in losses can have the effect of decreasing loss limitations (meaning RIC would have less of its pre-ownership change losses to off-set post-change gains).

§382 Unrealized built-in-gains/losses (“BIG” or “BIL”)

• Built-in gains/losses apply to fund with the ownership change; when it has a net unrealized built-in gain or loss, §382 limitation for any taxable year ending within a 5 year period beginning on the date of the merger is increased or decreased by recognized built-in gains or losses for the taxable year.

§382 Unrealized built-in-gains/losses (“BIG” or “BIL”)How to Calculate:1. FMV of assets less adjusted basis of assets equals net unrealized built-in-gains or built-in- losses.2. Compare to the lesser of:a. 15% of FMV of assets, orb. $10,000,0003. If 1 is not greater than 2, net unrealized built-in-gains or built-in-losses are de minimis & deemed to be zero.4. If 1 is greater than 2, then the fund has net unrealized built-in-gains (“BIG”) or built-in-losses (“BIL”) equal to the amount calculated in 1 above.

§382 Unrealized built-in-gains/losses (“BIG” or “BIL”)

Note that recognized built-in-gains and losses are calculated on an asset by asset basis when determining their impact on these limitations, although the initial calculation regarding whether the unrealized built-in gain/loss exceeds the de minimis amount is done on an aggregate basis.

§382 - How to Calculate Recognized BIG/BIL

• If either the acquiring or acquired funds have BIG/BIL, you might need to review a calculation to determine how much, if any, of the unrealized built-in-gains or unrealized built-in-losses were recognized in the current taxable year.

• This usually requires an analysis on a security by security basis. However, in certain situations, you may be able to do an assessment on a broader basis.

SAMPLE CALCULATION OF RECOGNIZED BUILT-IN-LOSS (“BIL”):

As of the merger date, acquired fund held the following assets which were sold in the year after the merger as noted below:

§382 - Notes to Prior BIL Example:

(a) - Fund has a net unrealized built-in-loss of $5,000 so only the sale of securities with unrealized built-in-loss as of the merger date (i.e., Securities B & C) can generate recognized built-in loss upon sale.(b) - Fund can recognize built-in loss on the sale of a security only to the extent of unrealized built-in-loss on the security as of the merger date.

§382 - Notes to Prior BIL Example Continued:

(c) -The total amount of built-in gains or losses that a fund can recognize is limited to the amount of the net unrealized built-in gain or loss as of the merger total, this amount is limited to $5,000 (the amount of net unrealized built-in-losses as of the merger date.)

Example #2 - §382 and 383

Facts: Assume same facts as Example #1, Fund A stock has

a value of $2,000,000 on September 15, 1999 and the long term tax-exempt rate is 6 percent.

Question: a.) What is the annual Section 382 limitation? B.) What is the short-year 382 limitation for the first tax

year ending after the date of the merger?

Example #2 - §382 and 383

Answer:a. Since the merger the annual Section 382 limitation is as follows:

Value of stock at merger date $2,000,000 Long term tax-exempt rate 6% Annual Section 382 limitation $120,000

b. Since the merger occurred on a date other than the last day of the taxable year, the amount of capital loss carryover utilized in the first year ending after the merger is further limited by Section 382 to $35,178 ($120,000 x 107/365).

Example #3 - §382 and 383

Facts for CLCO and Built-In Gain Situation: Mostly same facts as Examples #1 and #2 except for points below. Fund A has a net unrealized built-in gain of $100,00 at September

15, 1999, which is in excess of the de minimis amount. During 2000, Fund B realized $50,000 of gain attributable to the

unrealized built-in gains from the Fund A at the date of the merger.Question: What is the §382/383 limitation?

Answer for Example #3 - §382 and 383

Section 382/383 limitation as follows: Fund B net realized gain for 2000 $1,000,000 Annual Section 382 limitation $120,000 Realized built-in gains 50,000 170,000 Net Capital Gain for 2000 $ 830,000

The increase for any taxable year cannot exceed the net unrealized built in gain at the time of the merger, reduced by recognized built-in gains for prior taxable years.

Example #4 - §382 and 383

Facts for CLCO and Built-In Loss Situation: Mostly same facts as Examples #1 and #2 except for points below Fund A has a net unrealized built-loss of $200,000 at September

15, 1999, which is in excess of the de minimis amount. In 2000, Fund B realized $100,000 of loss attributable to the

unrealized built-in losses from the Fund A.

Question: What is the §382/383 limitation?

Answer to Example #4 - §382 and 383

Fund A Capital Loss Carryover 9/15/99 $600,000 Net built-in capital loss recognized in 2000 100,000 Total loss subject to limitation $700,000

Fund B realized gain for 2000 $1,000,000 Add: Built-in losses recognized in 2000 100,000 Total Gain , excluding recognized built-in-losses $1,100,000 Fund A Capital Loss Carryover used as limited by Section 382 (Example #2) (120,000) Net capital gain for 2000 $980,000 -------------

Answer to Example #4 - §382 and 383 Con’t

This limitation will apply to recognized built-in losses only to the extent the losses do not exceed the net unrealized built-in losses at the time of the merger, reduced by the recognized built-in losses for prior taxable years.

§384 Discussion

Provides that if either fund that is a party to the merger has a net unrealized built-in gain at the date of the merger, income to the extent attributable to recognized built-in gains for the 5 year period beginning on the date of merger shall not be offset by any pre-acquisition loss of the other fund. (Note: pre-acquisition loss can be CLCO, net unrealized built-in-loss, or possibly POL)

Example #5 - §384

Facts: Mostly same facts as Example #4 except for points below Fund B has a net unrealized built-in gain of $1,200,000 at

September 15, 1999 (date of merger), which is in excess of the de minimis amount.

Fund B has $1,000,000 of realized gain in 2000, which is all attributable to the recognized built-in gain.

Question: What is Section 384 limitation?

Answer - §384

Fund B net realized gain for 1999 $1,000,000Add: Built-in losses from Fund Arecognized in 1999 100,000 Gross Gains: $1,100,000Less: Realized built-in gain that cannot be offset by Fund A’spre-acquisition losses. $1,000,000Capital gain that may be offset by Fund Apreacquisistion losses (Section 384) - - - (1) $100,000 -----------Fund A loss limitation under Sections 382/ 383(Example #2) - - - (2) 120,000Loss allowable (lesser of 1 or 2) 100,000 Net capital gain for 2000 $1,000,000--------------