The IRS issued two pieces of guidance affecting money market funds (MMFs). In Revenue Procedure 2016-31, the IRS offers transitional relief for MMFs that receive contributions from their advisors to bring net asset value (NAV) up to $1.0000 as part of the MMF's conversion to a floating-NAV MMF before the October 14, 2016 deadline included in 2014 SEC rules. In Notice 2016-32, the IRS announces an alternative diversification test under Section 817(h) for segregated asset accounts that invest in government MMFs.

Revenue Procedure 2016-31

Background

MMFs generally seek to maintain a stable NAV of $1 per share. Historically, an MMF that maintained a portfolio of assets meeting certain maturity, credit-quality, liquidity and diversification requirements could issue and redeem shares at a price of $1 per share provided that the amortized per-share cost (i.e., the purchase price, adjusted for amortization of premium and accretion of discount) or the actual per-share value of its assets was between $0.9950 and $1.0050 (rounded to the nearest penny, $1). If a fund always maintained a stable NAV of $1 per share, investors would never recognize gain or loss on redeeming shares in the fund.

As a result of the financial crisis that began in 2007, the tight liquidity in the credit markets and significant redemption requests by investors, a few MMFs "broke the buck" and were not able to maintain a $1 NAV and others needed nonshareholder contributions to capital to stay at a penny-rounded $1 NAV. SEC regulations were issued in 2014 requiring institutional MMFs or "floating-NAV MMFs" (defined generally as any MMF that does not invest almost exclusively in government securities or limit its beneficial interest holders to natural persons) to issue and redeem shares at market-based values (rounded to the nearest 1/100th of a cent for a $1 NAV fund) beginning within two years (by October 14, 2016). As a result, floating-NAV MMFs will no longer be able to use amortized cost and penny rounding. These changes will increase the likelihood of changing NAVs, which would result in shareholders having gains or losses on redemptions. This in turn would affect tax reporting by fund shareholders and Form 1099 providers and potentially implicate the wash sale rules. Similarly, redemptions of MMF shares subject to liquidity fees would result in losses. Thus, the tax compliance burden would increase because it would now be more common to recognize gain or loss on redemption.

On the same day as the 2014 SEC rules were released, the IRS released proposed regulations (REG-107012-14) and additional guidance (Revenue Procedure 2014-45) intended to mitigate tax compliance burdens that would otherwise result from the SEC's amended MMF rules. The IRS guidance provided simplified wash sale and information reporting provisions to accommodate the new rules for floating-NAV MMFs. See Tax Alert 2014-1400.

Commenters on the IRS proposed rules noted that sponsors of an MMF converting to a floating-NAV MMF may wish to make contributions to the MMF so that, when the MMF transitions to a floating-NAV MMF, all shareholders receive the same value per share at the time of the transition (a top-up contribution).

The SEC rules require MMFs to disclose certain events. For example, if an MMF receives financial support from a sponsor, it must timely report it on Form N-CR. The IRS noted, however, that SEC Division of Investment Management staff have stated that they will not object if certain transactions providing financial support are not reported on Form N-CR (in particular, in the case of a top-up contribution occurring as part of a transition to implement the floating-NAV reform before the October 14, 2016 compliance deadline).

MMFs must meet distribution requirements to be taxed as a regulated investment company (RIC) and avoid imposition of excise tax under Section 4982. Section 852(b)(1) imposes a tax on a RIC's investment company taxable income (ICTI). Section 852(b)(2) defines ICTI as taxable income with several adjustments, including the exclusion of net capital gain and the allowance of a deduction for dividends paid. For an MMF to be taxed as a RIC, Section 852(a)(1) generally requires it to distribute at least 90% of its net income (other than net long-term capital gains) and receive a deduction for dividends paid during the tax year.

Transitional relief

The IRS explained that the distribution requirements in Sections 852 and 4982, if applied to adviser contributions, may make it impossible or impractical for the advisers of some MMFs to make contributions that raise the MMFs' NAVs to $1.0000. Responding to comments on the 2014 proposed regulations requesting guidance to facilitate such contributions, the IRS determined that excluding certain adviser contributions from ICTI for purposes of the distribution requirements in Section 852(a) is appropriate for these purposes.

Accordingly, Revenue Procedure 2016-31 creates a special rule for top-up contributions received by an MMF as part of a transition to implement the floating-NAV rules before the October 14, 2016, deadline. Specifically, the IRS stated that it will not challenge an MMF's treatment of such a contribution as an amount that is includible in ICTI for purposes of Section 852(b)(2) (taxable income of the RIC before any dividends paid deduction) but is excluded from ICTI for purposes of Section 852(a)(1) (the 90% distribution requirement). The revenue procedure also includes an example illustrating its application and the effects on income and excise taxes of retaining the contribution.

Notice 2016-32

Background

In 2014, the SEC amended certain rules governing MMFs, including Rule 2a-7, which, as amended, requires MMFs (other than government MMFs) to impose liquidity fees in certain circumstances. Amended Rule 2a-7 does not impose such a liquidity fee requirement on Government MMFs (i.e., generally MMFs investing almost exclusively in government securities). As a result, the IRS stated that it expects that some non-government MMFs will convert to Government MMFs.

Variable contracts, defined in Section 817(d), generally allow policyholders to select among several investment strategies, resulting in investment in different groups of assets. Each group of assets may be a "segregated asset account" as defined in Reg. Section 1.817-5(e). Under Reg. Section 1.817-5(b), a diversification requirement applies to each segregated asset account. Under this diversification requirement, investments of a segregated asset account are considered adequately diversified only if, with respect to the value of assets of the account: no more than 55% is represented by any one investment, no more than 70% by any two, no more than 80% by any three and no more than 90% by any four. In addition, no policy holder may have investor control.

For purposes of this separate asset account diversification requirement, each US government agency or instrumentality is treated as a separate issuer. Only a limited number of US agencies and instrumentalities, however, issue securities that MMFs may hold under Rule 2a-7. Often, such funds invest almost all their assets in Treasury securities, which is a single issuer. The IRS anticipates that increased demand for government securities resulting from the expected conversion of more MMFs to government MMFs is likely to make it more difficult for MMFs to acquire the assets necessary to both qualify as a government MMF and meet the diversification requirement.

Alternative diversification requirement

The IRS stated that it believes variable contracts should be able to offer government MMFs as an investment option. Therefore, to address the anticipated impediments to their availability and to allow concentrated investments in Treasury MMFs, the IRS announced that it intends to amend Reg. Section 1.817-5. Pending such regulatory amendments (or other further administrative guidance), Notice 2016-32 states that taxpayers may rely on an alternative diversification requirement contained therein for segregated asset accounts that invest in a government MMF. Specifically, a segregated asset account (within the meaning of Reg. Section 1.817-5(e)) is adequately diversified for purposes of Section 817(h) if: (1) no policyholder has investor control, and (2) the account either: (a) is itself a government MMF, or (b) invests all its assets in a government MMF.

Implications

Revenue Procedure 2016-31 facilitates the transition of an MMF to a floating-NAV MMF by virtue of top-up contributions by including the contributions in investment company taxable income but by excluding them from the 90% distribution requirement, thus facilitating capital contributions to bring the MMF up to a $1.0000 NAV per share at the time of the transition.

Notice 2016-32 eases the restrictions on investors, making it easier to have government MMFs (particularly those that invest solely in Treasuries) in their variable contracts as an investment option without violating the segregated asset account diversification requirements. Thus, government MMFs may become more widely used without the risk of violating the diversification requirement for a segregated asset account.

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