Jim Novakoff

Proposed Law to Defer Capital Gains on Funds

Representative Jim Saxton, a New Jersey Republican and Chairman of the Congressional Joint Economic Committee, has introduced significant legislation addressing the taxation of mutual funds. The proposed law, if enacted, would change the tax rules for many low- and middle-income investors. Saxton's bill, introduced in June, would relieve investors of the current burden of paying taxes on the capital gains distributions of mutual funds, even when the investor hasn't sold a single share.

In an exclusive interview with Indexfunds.com, Representative Saxton stated, “It is very unfair for certain types of investors to be taxed in a way that others are not taxed.”

Saxton introduced HR 4723 to solve the taxation problem in part by deferring the tax on reinvested capital gains until the shares are sold. Under the proposed legislation, up to $3,000 in annual capital gains taxes could be deferred, up to $6,000 for a married couple.

Representative Saxton saw the tax on mutual funds as not only inconsistent with the taxes on other investments, but disproportionately burdensome to low- and middle-income investors whose primary investment vehicles are mutual funds.

Currently, most mutual funds are “Investment Companies” under U.S. securities regulations. The Investment Company is a regulatory structure that allows a group of investors to pool investments under common investment management. Investment companies have their own tax rules under U.S. tax code.

Under the perntinent law, an investment company itself is not required to pay taxes on capital gains associated with its investment transactions, provided the managers annually distribute net capital gains to the beneficial owners. Those beneficial owners not otherwise exempt from paying taxes (e.g. charities) or owners not holding investments in tax-deferred accounts (e.g. IRAs and 401(k) accounts) pay the taxes on those distributions in the year in which they are distributed. These investors pay the capital gains taxes even if they themselves have not sold a single share of investment.

The investment company structure in some ways helps the investment company because the managers can buy and sell investments without concern for their own tax position. However, the rules work against investment companies when marketing mutual funds. Mutual funds compete for investor dollars with exchange-traded funds (ETFs), whose administrators can avoid annual capital gains distributions that result from redemptions. This competitive disadvantage could become more acute with the proposal of new SEC regulations that would force funds to reveal their after-tax returns.

The tax provisions that exchange-traded funds use to avoid making the distributions are well-known, but mutual funds are not able to take advantage of them due to different administrative structures (ETFs can still be forced to make capital gains distributions if underlying shares are sold to reflect the relevant index's constitution). Mutual funds also compete with portfolios of individual securities and separate accounts that offer more tax control.

The current tax rules are even worse for the beneficial owners of mutual funds because individual investors are forced to pay taxes annually on investment decisions that are outside their control. The tax rules also create a host of unintended consequences. Of particular concern is the recent impact of these taxes on investment returns. Investment companies have historically reported pre-tax investment performance. This pre-tax performance can be misleading because some investment managers generate more taxes than others. That is, a tax efficient mutual fund that returns 10% pre-tax may provide better returns to the taxable investor than another less tax-efficient mutual fund that returns 10.5%.

The tax impact of Saxton’s proposed legislation would be significant for many investors. His legislation is also important in that it turns the debate over what fair taxation is on its ear. The legislation goes a long way in answering the question: Are ETFs or mutual funds now taxed correctly? There is, or was, some discussion that it is ETFs that have an unfair tax advantage. Representative Saxon has stated that it is the mutual funds, not ETFs, that are improperly and unfairly taxed.

Congress and the mutual fund industry have for years been debating the proper way of reporting post-tax investment returns. Literally millions of dollars have been spent developing methodologies, proposed regulations, and legislation to develop and implement the reporting of post-tax returns. Representative Saxon has suggested the obvious solution to the reporting problem: get rid of the annual tax.

Surprisingly, the mutual fund industry did not initially support HR 4723. The industry associations representing mutual fund families are now looking more seriously at the bill.

“The mutual fund industry was initially lukewarm, but now they are supportive”, says Representative Saxton.

In a separate interview for Indexfunds.com, Christopher Frenze, the Chief Economist for the Congressional Joint Economic Committee, stated that the industry's lack of enthusiasm was "...a tactical decision, not a substantive decision."

Indeed, it seems self-evident that if the bill decreases the tax exposure of individual investors at no additional expense to the funds, fund managers would support it.

Also interesting is that the bill has not received more support from individual investors thus far. Frenze believes a lack of attention and general ignorance regarding the issue are major hurdles for the bill. Saxton states that getting popular support for HR 4723 is the next step required to get it passed, and interest in the bill is increasing.

HR 4723 does not solve the tax problem altogether in that it limits the amount of capital gains that can be deferred. This limitation seems to penalize those that have chosen to save more. The limitation also has the potential to increase the complexity of annual tax returns of investors needing to report the deferred capital gains and then take a credit against them. Investors in other investments do not need to report annual capital gains because either there are none (as is the case with ETFs) or they are not relevant (as is the case with individual securities held for the year). It would be even more just and simpler if HR 4723 legislated that the act of reinvesting annual capital gains distributions is not a taxable event. Nonetheless, HR 4723 shows that Representative Saxton has a good understanding of the complex problem of mutual fund taxation and the steps needed to fix the system.

Prospects for HR 4723 are uncertain in this election year. Odds are against quick passage, if the long battle to raise IRA limit is any indication. In the meantime, a very influential congressman has acknowledged the unfairness of a tax that individual investors have been complaining about for years. He also supports tax relief for mutual fund investors as opposed to adding additional taxes on other investment products to level the playing field.

Jim Novakoff, CFP is President of Levitt, Novakoff & Company, LLC in Boca Raton, Florida