The mutual fund industry is pushing to make a relatively obscure, short-term capital gains tax exemption, broadly known as the American Jobs Creation Act of 2004, a permanent rule in accounting books before it expires in 2008.
A provision that reduced a tax bias against U.S. mutual fund investment by foreign investors, the law applies to taxable years beginning after Dec. 31, 2004 and before Jan. 1, 2008. When President Bush signed it last year, the act was hailed as the most sweeping change in business tax laws since 1986.
At the recent Investment Company Institute Tax & Accounting Conference in Chicago, the industry's leading accountants were encouraging registered investment companies with qualified short-term gains and non-resident shareholders to expedite the determination and designation of all or a portion of their dividends as short-term capital gains dividend. The designation is due 60 days after the fund's taxable year. Taxes on interest gains, such as from a bond fund, are also forgiven to foreign investors.
The provision, which is often referred to by industry accountants as the "flow-through act" or the "leveled playing field legislation," does not require reinvestment of short-term capital gains. Nor was it designed to help foreign investors skirt U.S. tax laws, said one industry tax and accounting expert, who wished to remain unidentified. "It's designed to encourage foreign investors to invest in the U.S.," the expert said, noting that U.S. investors enjoy the same treatment overseas.
Prior to the act, short-term capital gains earned by foreign investors in U.S. mutual funds or through a U.S. portfolio management firm, were taxed by upwards of 30%. Other investment vehicles, such as hedge funds, offshore funds and separately managed accounts, are exempt from the withholding.
In short, as ICI President Paul Schott Stevens said in his organization's support of the act last year, it removes "a significant U.S. tax barrier to foreign investment in U.S. mutual funds."
Although the broader Jobs Creation Act includes other provisions that do speak to domestic investors - such as relief from unfair currency exchange rates and withholding exemption on certain interest earned by a fund if it owned property - they are extremely complex and would create a significant administrative burden on fund companies for investors to realize any benefit, said Shawn K. Baker, a principal who leads the investment management industry tax practice at PricewaterhouseCoopers.
And while the flow-through provision doesn't expire until 2008, experts agree that, given the premium investors place on the stability and predictability of the tax environment in which they invest, the sooner lawmakers address the issues, the better.
"It's not terribly helpful, from a tax policy perspective, to have rules out there that only exist for the short-term, when our business is geared to the long-term," Baker said.
But opponents say the act caters to special interests, including U.S. financial firms selling products to foreign investors. Prior to its passage last year, Sen. John McCain (R-Ariz.), went so far as to call the act "the worst example of the influence of the special interests I have ever seen."
The Drum Major Institute for Public Policy, a New York-based advocacy group for middle-class American families, has called it a "massive tax giveaway to closely tailored special interests" and an accounting gimmick that "prioritizes massive tax cuts for the most profitable American corporations."
Leveling the playing field for foreign investors, said Andrea Batista Schlesinger, executive director of the Drum Major Institute, actually comes at the expense of middle-class Americans, who own a disproportionately small percentage of stock in the first place and who down the road would bear the brunt of corporate tax breaks.
"It's important to recognize that while middle-class households increasingly own some stock, either directly or through mutual funds, fewer than 10% of the assets of the average middle class household were in stock investments of any kind in 2001," she said.
Citing statistics from the Economic Policy Institute in Washington, Schlesinger noted that the wealthiest 10% of U.S. households directly or indirectly own 77% of stock market holdings, whereas the middle class and aspiring middle class together own less than 12% of stock market holdings.
"Far more than their mutual funds, the middle class relies on their income from work," she added, noting that the bill was ostensibly designed to encourage new jobs, "yet there is nothing in it to require, or even encourage, companies to create a single job."
The fund industry has seen otherwise.
Brent R. Harris, a managing director at the Newport Beach, Calif.-based PIMCO, a $493 billion bond fund manager, said it's too early to put a dollar estimate on the impact of the act and its flow-through provision on assets under management. But that doesn't diminish the importance it has to the fund industry, he said.
"Some U.S. fund companies have taken the view that they don't much care because when they sell to offshore investors, they sell only offshore funds - Dublin or Luxembourg or the Caymans, might be most popular - but our view is not that way," Harris said. "While we have those options that fit certain pockets, we think it's still a benefit to the market overall to offer U.S. funds abroad."
For example, Harris offered, in many cases it makes more sense to place a U.S. fund with an established track record into a foreign market, rather than cloning an entirely new fund, whose start-up costs would be borne by its shareholders. An established fund also brings with it highly diversified holdings and extensive assets under management, key selling points to many investors.
Absent the flow-through provision, Harris added, the U.S. financial services industry would be encouraged to develop offshore fund complexes with offshore subsidiaries using offshore custodians.
"So what have you done? You've offshored a very profitable, high tax-paying part of the economy. It should resonate that anything that pushes big financial companies offshore and their profits, too, would be an inappropriate tax policy," Harris remarked. Down the road, the provision could mean more jobs, too.
"If foreign investors were to begin to flock to U.S. funds, we'd have to hire people to staff the telephones and answer questions, new portfolio managers to run the extra money. It would obviously add jobs and add profits. It's hard to imagine, in any way, it being a negative," Harris said.
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