Subject: SEC File Number S7-09-00 Date: 06/26/2000 11:57 AM SEC File Number S7-09-00 (The following was written using Word 97 version SR-2) Comments on Proposed Rule for Disclosure of Mutual Fund After-Tax Returns As both a chartered financial analyst who works in the field of performance measurement at Dow Jones Indexes and an enrolled agent who deals each winter with the complexities of the current U.S. tax code for scores of otherwise intelligent investors who can't comprehend its rules, I am taking this opportunity to state my personal objections to your proposed rule and form amendments under the Securities Act of 1933 and the Investment Company Act of 1940 regarding disclosure of the effect of taxes on the performance of open-end management investment companies. Having read your proposed rules and the self-serving arguments presented to justify them, I am left wondering if anybody involved in your rulemaking process has ever prepared his own tax return. It is blatantly obvious that any resemblance between the SEC's so-called "after-tax returns" and the after-tax results real taxpayers would receive on their mutual fund investments would be purely coincidental. The last thing the investors you think you would be helping need is another series of meaningless numbers cranked out using a "standardized formula" based on a massive number of heroic assumptions that bear no resemblance to what any taxpayer--let alone those in the 39.6% tax bracket who can afford professional tax and investment advice--would actually experience. Do us all a favor and drop this proposal. If you really want to help investors, instead of accountants and tax lawyers, you should instead mandate that all mutual funds use the "specific identification method" in reporting asset sales. That, at least, would force the funds that do not already use this method to trade in a more tax-efficient manner. Requiring funds to describe in their periodic reports the tax-management strategies they use also would be useful, as would be better disclosure of dividend ex-dates (which would make it easier for investors to avoid buying tax liabilities). Furthermore, in cooperation with the Internal Revenue Service, you should be working to make it easier for fund investors themselves to use the "specific identification" method when they dispose of part of a fund position. As for my specific objections: 1. Virtually all people who file individual or joint returns are calendar-year, cash basis taxpayers. Realizing this, the IRS requires mutual funds to report distributions on a calendar-year basis on Form 1099-Div. Furthermore, in order to prevent either mutual funds or individual taxpayers from gaming the system, distributions based on one calendar year's performance (regardless of when the mutual fund actually ends its fiscal year), but paid in January of the next year, are taxed as if constructively received in that calendar year. Fiscal-year after-tax returns--even if they could be calculated in a meaningful manner--would be pointless, even if the fund opted to retain its capital gains, pay tax on them and flow through both the income and the tax payment to individual shareholders on Form 2439. 2. Assumption 6, Timing and Method of Tax Payment, requires any taxes that might be due on a distribution be paid out of that distribution at the time it is reinvested, rather than when payment to the IRS would be required. This distortion, caused by your introduction of accrual-based accounting conventions into a cash-based world, would have a significant effect on the compounding rates of bond funds that pay monthly dividends. This also would distort the timing of tax liabilities incurred by investors who have their monthly dividends sent to them. Estimated tax on an income distribution constructively received on January 31, for example, would not be due until April 15 at the earliest. Even if the taxpayer put aside 39.6% of the distribution on January 31, it is highly unlikely that the cash would have been stuck in a coffee can and buried in the back yard. I have seen attempts to compensate for the time value of the money by considering it invested at the fed funds or T-bill rate. They at least consider the problem, although they add greatly to the complexity of the bookkeeping required to calculate your pointless returns. 3. Assumption 7, Tax Treatment of Distributions, states that "non-taxable returns of capital" would be assumed to result in no taxes. However, Assumption 8, Capital Gains and Losses Upon a Sale of Fund Shares, states, "A fund would therefore be required to track the actual holding periods of reinvested distributions and could not assume that they have the same holding period as the initial $1,000 investment." Any return of capital reduces the taxpayer's basis in the investment, and therefore would have to be accounted for when the fund shares are assumed to have been sold. It also is improper to assume that reinvested distributions have the same holding period as an initial investment; even an entire sale of a position requires the short-term and long-term portions be reported separately in order to be taxed at the appropriate rates (if you don't believe me, take a look at a Schedule D). 4. Try implementing your proposed rules when you have distorted all of the dividend reinvestment results over an extended period of time, such as 10 years, by assuming only 60.4% of the proceeds actually were reinvested. You will be compounding the errors introduced into your return series. 5. Proposed Narrative Disclosure. I would suggest that the plain English disclosure begin with a warning that the accompanying table, produced at fund shareholders' expense under specific SEC orders, is based on totally unrealistic assumptions also mandated by the SEC, and that the so-called "after-tax returns" would be entirely different if another set of just as simplistic assumptions (such as all distributions were reinvested and that the cash to pay the taxes on those distributions was provided on April 15 of the following year by the Tooth Fairy) had been used. They, of course, must also warn that the hypothetical after-tax results presented in the tables say absolutely nothing about what the fund's future tax exposures will be. 6. How to benchmark the results? Using the appropriate pre-tax total return stock index for the asset class represented in the mutual fund is the only alternative. It should be noted that AIMR, which should know better, is concurrently working on a proposed set of after-tax indexes. However, the assumptions needed to convert current stock index total returns into an "after-tax" series are even more heroic than those required under your proposed guidelines for funds. I have no doubt that my employer, Dow Jones Indexes, can accurately calculate indexes using any set of rules the SEC mandates. I also have no doubt that the resulting figures, as well as those calculated by competing index providers, will bear no resemblance to reality. 7. Cost-Benefit Analysis. As your own proposal notes, the disclosures will be entirely useless to the investors who hold the funds in tax-sheltered retirement accounts; however, tax-sheltered investors will bear part of the costs of calculating and disseminating them by the increases they will make in fund expense ratios. Besides the costs of setting up the accounting systems for the initial calculations, the fund managers also will face the additional cost of maintaining the data for the so-called "after-tax" fund performance figures. And everybody will get to bear the costs of printing the fatter semi-annual and annual reports needed to contain the explanations of the "after-tax" calculations. In conclusion, I recommend that this well-intentioned but costly and highly distorted attempt at improving mutual fund disclosures be abandoned before it can do any harm. Few investors now read the prospectus for any fund they invest in, and even fewer would attempt to interpret the footnotes needed to explain why their own tax liabilities bear no resemblance whatsoever to the SEC-mandated calculations. If nothing else, think of the trees you could save by abandoning this project. Sincerely, James M. Nevler, CFA, EA 224 Westgate Drive Edison, NJ 08820