With the recent issuance of Internal Revenue Service and U.S. Treasury Department guidance on capitalization, a drawn out conflict with the fund industry over the tax treatment of fund start-up costs appears to be drawing to a close. The Investment Company Institute has not issued an official comment on the issue, but it has indicated that the new rules do not go far enough in terms of the costs that can be expensed.

While the general interpretation is that the new guidance signifies a victory for the industry, it only addresses part of the issue. According to John Collins, an ICI spokesman, the ICI wants fund sponsors to be allowed to expense all costs associated with launching a fund, not merely the internal costs, as the new guidance provides. External costs would cover fees paid to consulting firms, outside lawyers and other experts and should also be covered, Collins said.

The ongoing issue has been to what extent fund sponsors can expense costs associated with creating a fund. Since the IRS has generally allowed firms to deduct their internal start-up costs, most fund firms already expense most of those costs. The practical implications of the new guidance are minimal, but codified rules should provide an iron-clad defense against legal action, industry observers said.

But the IRS has shown that it will take action if funds try to deduct both internal and external costs. In 1998, the IRS contested Fidelity Investment's accounting procedures after the firm deducted all of its fund start-up costs. FMR, Fidelity's parent, sued the IRS, but lost the decision. The firm has since appealed and the case is still pending.

New Rules ...

The new guidance, which was issued in mid-January in the form of an advanced notice of proposed rule making (ANPRM) is a concession on the part of the IRS and would allow fund sponsors to expense start-up costs, said Alan Munro, a tax specialist with Arthur Andersen. Those costs include the internal tax, corporate, legal and marketing costs associated with the creation of a fund, including a portion of employees' salaries who were involved in the fund's creation, Munro said.

The IRS and Treasury Department have requested public comment on the ANPRM by March 25. Following the consideration of those comments, the IRS will then release rule proposals, which will also be commented on before any official rules are implemented.

... not Sufficient

Those new rules do not jibe with the fund industry, however. "The IRS doesn't address those [costs] in [the ANPRM], and so I think there has been a divergence of views between the IRS and the fund industry," Collins said. "I would stay tuned. I don't know what the fund industry's response is going to be."

The ICI will send its comments before the March 25 deadline.

For years, the ICI has been pressuring the IRS to allow fund companies to deduct fund startup costs, but since the mid-'90s, the IRS has taken the position that they prefer those costs to be capitalized and amortized over a certain number of years. In 1999, the ICI suggested that the IRS change the amortization period from 15 years to five years, but the IRS never released formal guidance. Then last year, the ICI took back their compromise and asked that fund firms be allowed to expense start-up costs immediately. The industry was apparently shunned when the issue did not make the IRS and Treasury Department's 2001 priority business plan.

While mutual fund tax lawyers are interpreting the guidance to mean funds can expense internal costs, the IRS does not mention the issue specifically or mutual funds at all in the guidance. Andrew Keyso, a member of the IRS' office of chief counsel and the drafting attorney on the ANPRM said he had not heard of the mutual fund start-up cost interpretation.

"Our discussion focused on general principles with regard to capitalization," Keyso said. "We didn't really get into specific industry issues."

Still, there are numerous rules in the ANPRM under which mutual fund start-up costs could be categorized, allowing firms to deduct them, Munro said. Those costs can be substantial, but for most firms, the guidance will have little practical effect because they're already expensing a lot of the costs.

An Extra Layer of Protection

"In the past, most fund sponsors have been deducting these costs anyway," Munro said. "The thing is now, if the rules are implemented, they would be able to point to them as further defense for doing so."

Although many firms expense those costs, the ICI is very interested in seeing that the IRS address the issue to avoid conflicts in an area where there has been various interpretations, said Collins.

"There is not necessarily a huge practical effect that would affect firms and shareholders, but with clarity from the IRS, the issue could certainly be firmed up," Collins said.

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