Thursday, June 29, 2000
Jonathan G. Katz
Secretary
Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549-0609
Re: File No. S7-09-00: Disclosure of Mutual Fund After-Tax Returns
Dear Mr. Katz,
We appreciate the opportunity to comment on the proposed rule requiring mutual funds to disclose after-tax rates of return. We believe the Commission's proposal is excellent and continues in the tradition of reform reflected in the recent changes to Form N-1A. The new disclosure requirements focus on information central to investment decisions, and enhance the comparability of information about funds. The current proposal reflects the Commission's belief that the primary purpose of the disclosure in a fund's prospectus is to help an investor make a decision about investing in the fund. Consistent with this belief, the proposed rules will provide investors with prospectus disclosure that presents clear, concise, and understandable information about an investment in a fund.
Confluence Technologies provides the mutual fund industry with systems that allow fund complexes to calculate their standard rates of return. Presently, our applications are used by more than 40% of U.S. mutual funds to calculate returns on a daily basis. In our comments we have chosen to focus explicitly on the calculation of the proposed returns and what they represent to investors. This is our area of expertise.
Overview
In addressing the question of how to best represent the tax consequences of investing in mutual funds, the Commission must determine which rates of return to present to investors, as well as the mathematical assumptions used in the calculation of the returns. In this letter, we offer support to an alternative pre-liquidation after-tax return. This alternative is mentioned as a consideration by the Commission but is not a part of the proposed rule. In this letter, we hope to explain why we think the alternative pre-liquidation calculation might better serve the Commission's goals.
Additionally, and what we consider more important than our suggested alternative, this letter highlights the elements of the rule that we believe must be implemented exactly as they have been proposed. The Commission offers a set of essential key assumptions for use in the return calculations. In our comments we hope to demonstrate the strength of the proposed assumptions and to highlight the serious distortions that would arise from the adoption of some of the alternatives under consideration.
A. The Requirement to Disclose After-tax Returns
The problem of reporting useful after-tax returns is the problem of separating the tax impact of the investor's decisions (buy, hold, or sell fund shares) and the impact of the portfolio manager's decisions (buy, hold, or sell securities within the fund) on their investment returns. Additionally, calculations should result in numbers that allow investors to accurately compare mutual funds in terms of their after-tax performance.
The Commission proposes the use of both pre-liquidation and post-liquidation rates of return. "Pre-liquidation after-tax rate return assumes that the investor continues to hold fund shares at the end of the measurement period, and, as a result, reflects the effect of taxable distributions by a fund to its shareholders but not any taxable gain or loss that would be realized by a shareholder upon the sale of fund shares. Post-liquidation after-tax return assumes that the investor sells his or her fund shares at the end of the measurement period, and, as a result, reflects the effect of both taxable distributions by a fund to its shareholders and any taxable gain or loss realized by the shareholder upon the sale of fund shares." 1
In the present proposal, the pre-liquidation returns are used to show the tax impact of portfolio manager decisions, while post-liquidation returns are used to show the tax impact of portfolio manager decisions, as well as the tax impact of investor decisions to sell fund shares. The Commission recognizes that both are essential pieces of information. However, the present proposal does not yet fully address either the question of portfolio manager decisions or investor decisions.
We believe that the current proposal only models investor decisions, and the current decision set modeled is incomplete. In the following section, we hope to show why this is the case. We will then look at how one might best isolate the tax impact of portfolio manager decisions, and conclude this section by offering support to an alternative pre-liquidation after-tax return. The proposed modification can both reduce the reporting requirement for funds and increase the comparability of the returns between funds.
Demonstrating the Tax Impact of Investor Decisions on Mutual Fund Returns
The proposed table of four returns concisely demonstrates the impact of taxes upon fund returns in a clear, intuitive, and useful manner:
If You Continue To Hold Your Shares at End of Period
Before-Tax Return
After-Tax ReturnIf You Sell Your Shares at End of Period
Before-Tax Return
After-Tax Return
However, the captions accompanying the calculations reveal that the numbers are meant to show how taxes will impact an investor's returns as a consequence of the investor's decision. The table models the choice to buy and hold a fund (pre-liquidation) as well as the choice to buy and sell a fund (post-liquidation). The problem with reporting a "buy and hold" and "buy and sell" choice is that the impact of sales charges (front-end loads, back-end loads, both-end loads, no-load) upon the returns is incomplete and underrepresented. The pre-liquidation returns reflect front-end sales charges but not back-end sales charges. This penalizes front-end loaded funds because back-end loaded funds would report higher returns in a pre-liquidation scenario. The back-end load is hidden, and while it is reflected in the post-liquidation return, its impact is obscured by the additional taxes associated with the sale of fund shares. This leaves the investor without a pre-liquidation calculation that can be used to compare the performance of funds with different sales charge structures.
Could the problem be that only two of the four possible choices facing investors are represented? The current proposal includes a "buy and hold" scenario that reflects front-end loads but no back-end loads. It also includes a "buy and sell" scenario in which reflects both front-end and back-end loads but introduces the additional taxes on the sale of fund shares. There are two additional scenarios in the investor's complete decision set that are not represented. The third investor decision is a "holding period" scenario. This scenario would assume you had already purchased a fund (no front-end loads reflected) and did not sell it at the end of the measurement period (no back-end loads reflected). The fourth scenario is a "held and sell" decision. This scenario would assume you had already purchased a fund (no front-end loads reflected) and sold your shares at the end of the measurement period (back-end loads reflected). The corresponding captions for these two additional scenarios might be:
If You Had Already Purchased the Fund Prior To The Measurement Period And Continue To Hold Your Shares at End of Period
Before-Tax Return
After-Tax ReturnIf You Had Already Purchased the Fund Prior To The Measurement Period And Sell Your Shares at End of Period
Before-Tax Return
After-Tax Return
The problem with adding the additional investor scenarios is not only that it would add four more calculations to the proposed disclosure, but it also offers no calculation that allows investors to meaningfully compare funds in a way that both isolates the tax impact of portfolio manager decisions and consistently shows the impact of sales charges. The differing sales charge structures only emerge in the differing investor decision scenarios, and never in a way that funds can be compared regardless of the structure of their sales charges. Additionally, the application of the back-end load is always obscured by the additional taxes associated with the sale of fund shares. Under the current proposal, as well as under a scenario in which the complete investor decision set is modeled, there is no way for an investor to compare a front-end loaded fund to a back-end loaded fund in terms of tax efficiency.
Demonstrating the Tax Impact of Portfolio Manager Decisions on Mutual Fund Returns
In this section, we will offer support for an alternative pre-liquidation rate of return. We will discuss why the alternative might better serve the Commission's goals and we will speak to the legitimate concerns about its potential shortcomings. If we momentarily abandon the model of mapping directly to the investor's decision set, we can reexamine the objective of the pre-liquidation after-tax return. The goal for the pre-liquidation after-tax return calculation should be to:
If we wanted to truly isolate the ability of the portfolio manager to achieve tax efficient returns, we might create a new after-tax return that excluded investor activity altogether. The result is mathematically identical to the "holding period" scenario described above of an investor who had already purchased a fund and was merely holding it during the performance period. In terms of the calculation, it would eliminate all sales charges or fees (front-end as well as back-end loads) associated with the act of purchasing or selling the fund.
The strength of this "holding period" return is that it isolates the decisions of the portfolio manager from those of the investor. Additionally, it is superior to the current pre-liquidation after-tax return in that the result could be meaningfully compared between mutual funds regardless of the structure of sales charges. The obvious problem with this "holding period" after-tax return is while it is a useful number for comparing portfolio managers, it ignores the fact that sales charges on the entry or exit from a fund significantly impact returns achieved by investors. Even though the holding period after-tax return isolates the portfolio manager's effectiveness from shareholder decisions, shareholders do not buy portfolio managers, they buy mutual funds and many mutual funds have sales charges that impact their returns. An investor might select one fund over another because of the manager's consistent record of achieving higher and more tax efficient returns only to discover that the superior performance evaporates amid the sales charges of the fund. Consequently, a more useful comparator in making an investment decision would be a pre-liquidation after-tax rate of return with both entry and exit fees applied. This would allow investors to use a single number to compare and rank all funds in a way that isolates the portfolio manager's decision from the investor's decisions and reflects the structure of fund sales charges.
The Commission indicates in the proposed rule that this option has been considered, but was not a part of the proposed rule because of a very real concern that "investors would be confused by a pre-liquidation after-tax return measure that assumed no sale of fund shares for purposes of computing tax consequences but nonetheless reflected fees and charges payable upon a sale of fund shares."2 This confusion is a legitimate concern because the alternative pre-liquidation return is, in fact, not a pre-liquidation return.
The confusion, however, is not inherent in the calculation but simply in the inherited term "pre-liquidation." Early in industry discussions on the topic of after-tax returns, the term began to be associated with calculations that do not reflect taxes associated with the sale of fund shares. Thus, it is difficult to begin thinking about a calculation that accomplishes this same goal, but is not a pre-liquidation return. The confusion is compounded by the fact that throughout this letter we have referred to the idea as an alternative pre-liquidation return. Additionally, the Commission asked for comment regarding whether to "require funds to reflect the deduction of any fees and charges payable upon the sale of fund shares in pre-liquidation after-tax returns or take some other approach."3
The term pre-liquidation implies an investor outcome. It is the return before the investor liquidates. This alternative calculation is not a return reflecting one's behavior as an investor, but the behavior of the fund (portfolio manager decisions regarding turnover and investment company decisions regarding sales charges). A new term would need to be applied to avoid the internal contradiction. One approach might be to refer to a "fully-loaded pre-liquidation taxes rate of return" and a "fully-loaded post-liquidation taxes rate of return." This is now using the term "liquidation" to modify the word "taxes" rather than imply an investor action. A more descriptive caption might be a Rate of Return Net of Sales Charges and Taxes on Fund Distributions.
This alternative calculation is the best number for comparing the after-tax performance of funds independent of investor behavior. Applying an appropriate description to the number can avoid potential confusion surrounding the calculation.
A Complete Solution
As we have seen, the shortcoming of the current proposal is that it does not accomplish the goal of showing the impact of investor decisions because it leaves out the complete decision set. It does not accomplish the goal of isolating the impact of portfolio manager decisions because it introduces the impact of price structure for only certain types of funds. Lastly, it does not accomplish the goal of providing a number for meaningfully comparing funds on the ability of the portfolio manager and the price structure of the fund.
There are two approaches the Commission might take to solve this dilemma. The first would be to retain the clear and understandable investor scenario-driven approach of the existing proposal, but to add the two missing decision scenarios and the Rate of Return Net of Sales Charges and Taxes on Fund Distributions (front and back-end loaded pre-liquidation taxes return) for comparison purposes. This would provide the investor with the complete set of tools necessary to select a fund, as well as understand the tax impact of their decisions on their returns. The shortcoming of this approach is that it adds five new calculations to the existing proposal.
The second option, and the option we recommend, is to eliminate the current pre-liquidation before and after-tax returns, and replace them with a single Rate of Return Net of Sales Charges and Taxes on Fund Distributions. Additionally, the post-liquidation before and after-tax returns should be renamed to be consistent with this alternative calculation. This will leave the performance table with three rates of return:
The first calculation is mathematically equivalent to the existing standard rate of return or, what is called under the new proposed rules, a post-liquidation before-tax rate of return. The second calculation is the new return we have described above. The third calculation is the mathematical equivalent of the currently proposed post-liquidation after-tax rate of return.
We believe that comparing the before-tax return with the post-liquidation return will provide investors with a band representing the set of possible outcomes over the life of an investment regardless of their investment decision. Their results will not be better than the pre-tax return and no worse than the post-liquidation return. The new Rate of Return Net of Sales Charges and Taxes on Fund Distributions provides the means of comparing the quality of a fund's management and pricing structure to any other fund. This set of three calculations would more concisely meet the goals of the Commission's proposal.
The only shortcoming of this approach is the loss of the admittedly more intuitive captions of the current proposal. They have an attractive investor-centric quality that is consistent with the Commission's efforts to help investors make better-informed decisions. However, in this case, it is at the cost of the quality of the content and the genuine usefulness of the numbers. While, it is true that the alternative we propose may be less easily understood than the current proposal, it need not be, as the Commission has expressed concern, inherently confusing.
The proposed modification can both reduce the reporting requirement for funds while increasing the comparability of the returns between funds.
B. Location of Required Disclosure
We agree with the Commission's proposal that the after-tax performance numbers be located with the existing performance information. It is important that all performance numbers are kept together in the same section of the documents in which they are published for comparison purposes.
C. Format of Disclosure
If our suggestions regarding the returns were adopted the standardized tabular format (including the optional since inception return) might be represented as follows:
AVERAGE ANNUAL TOTAL RETURNS | ||||
(For the periods ended ____) |
1 Year |
5 Years |
10 Years |
Since Inception |
Return Net of Sales Charges |
___% |
___% |
___% |
___% |
Return Net of Sales Charges and Taxes on Fund Distributions |
___% |
___% |
___% |
___% |
Return Net of Sales Charges, and Taxes on Fund Distributions and Sale of Fund Shares |
___% |
___% |
___% |
___% |
Index
|
___% |
___% |
___% |
___% |
F. Formulas for Computing After-tax Return4
In standardizing return calculations, the Commission defines a set of guiding principles that these calculations must be robust, extensible and sustainable. They must not only meet the needs of the industry today, but must also be forward looking and sustainable in the future. In the proposal under consideration, the Commission has set forth an excellent approach to the mechanics of the return calculations. We believe that the proposed set of assumptions as they exist are significantly more robust, extensible, and sustainable than proposed alternatives.
Robust
The calculations must be accurate, meaningful and useful to as wide an audience as possible.
Extensible
Under the proposed rule, Form N-1A will continue to permit, but not require, a fund to include returns in the performance table for the life of the fund if it exceeds 10 years. Consequently, the formulas must be applicable to funds whose histories extend well beyond the limit of the standard 10-year measurement period. Additionally, fund companies regularly apply the existing principles set forth by the Commission for calculating standard rates of return for measurement periods well in excess of the 1, 5, and 10-year returns. Among these calculations are many non-standard fixed time periods (monthly, quarterly, annually), but also for incremental periods (month to date, quarter to date, year to date) and returns for rolling periods (1-year rolling rate of return).
Sustainable
A quick review of the history of the tax code, and the history of the typical mutual fund investor, will show that the assumptions we make today are likely to change tomorrow. The rules proposed must sustain the investor and the industry through future changes in the tax code and changes in the demographic makeup of the investing population.
Using these three guiding principles we have examined the Commission's proposed rule and found not only does the proposal offer the best set of assumptions, but that even small deviations from what the Commission has proposed could unwittingly result in a disaster for investors and the mutual fund industry.
1. Tax Bracket
We support the Commission's proposal that after-tax returns be calculated assuming that distributions, and gains or losses on a sale of fund shares, are taxed at the highest applicable individual federal income tax rate. The application of the highest federal income tax rate offers a "worst-case" scenario, which, when used in conjunction with the before-tax return, offers the investor a full range of potential outcomes. We also believe the use of the highest tax rate is consistent with the application of the highest loads in the standard returns presently calculated for fund performance. We all recognize that the load amount could be more or less depending upon an individual investor's decision, but the Commission sensibly requires a worst-case assumption. This has been a topic of considerable interest among investors and industry participants. Some individuals have recommended using the bracket of an "average investor," while others suggest breaking out individual tax brackets. Neither alternative approach is unreasonable; however, we believe the current proposal to use the highest federal tax rate is best.
Why not an intermediate tax rate?
The use of an "average investor's" tax bracket or some other intermediate income level is intuitively attractive but it lacks the robustness, extensibility and sustainability of the highest federal tax rate.
An intermediate rate is less robust than the highest rate in that it limits the potential usefulness of the numbers to anyone with an income above the "average." An intermediate rate will understate the impact of taxes to many investors and offer no sense of the potential severity of the unknown impact. The advantage of the highest rate is not that it exactly matches an individual investor's return, but that it offers a "worst case" boundary which, when compared to a before-tax return provides a meaningful range to the investor. Such a range is useful to any investor who pays taxes, whereas the use of an intermediate rate either overstates or understates performance for a given individual and leaves investors without an upper boundary case. Consequently, the calculation provides no meaningful content to an investor whose income is higher than the intermediate amount. Additionally, the assumption errs by understating the potential impact of taxes, which would undermine the whole goal of the proposed rule.
The use of an intermediate tax rate is also less extensible than the highest federal tax rate. As the investing community changes over time, the income of the average investor will also change, not only because of inflation but also because of changes in the demographics of the typical investor. Additionally, fund companies that want to provide after-tax returns for periods greater than ten years (since fund inception for example) have no basis for the income assumption of the average investor. Some funds have a performance history going back decades - would fund companies hypothesize the income of a typical investor in the 1940's?
Lastly, the use of an intermediate tax bracket is not as easily sustained as the highest federal rate. The highest federal tax rates are publicly available and are published on an ongoing basis as a part of the maintenance of the tax code. There is no need for administrative processes or committees to create and maintain a new, invented income level for this particular regulatory application. In a sense, using the highest federal rate leverages the existing government infrastructure rather than extending it unnecessarily.
Why not multiple tax rates?
The use of reporting returns for each individual tax bracket is attractive because of its robust completeness; however, it fails the test for extensibility and sustainability. The number of tax brackets has changed over time and will continue to change. Consider the number of brackets for the Married Filing Jointly tax category in some sample years:
| Year | # of Brackets |
| 1979 1982 1987 1999 1993 1999 |
25 15 5 3 5 5 |
Applying the current five-bracket tax code makes it impossible to compare returns that extend into the past. Of course, creating a return for each tax bracket also assumes that the personal income tax code will retain its existing structure moving into the future. Applying the highest federal tax rate will work regardless of the number of brackets that come and go over time. Applying the highest federal tax rate will even work if a flat tax is adopted.
Neither the use of an "average investor's" tax bracket nor the use of each individual tax bracket are mathematically more complex than using the highest tax bracket; they are, however, less robust, extensible and sustainable.
2. Historical versus Current Tax Rates
We agree with the Commission's proposal to apply historical instead of current tax rates in the calculation of after-tax rates of return. To clarify, we believe that tax rates applied to distributions should be those in effect at the time of reinvestment. The tax rates applied to the gain or loss on the sale of fund shares should be those in effect at the time of the sale. This approach will yield correct rates of return that do not suffer from the distortion of the mathematical anachronism introduced by the backward application of current tax rates. The Commission's proposal is extensible in that historical tax rates are publicly available, and sustainable in that the tax code is published on an ongoing basis. During our independent research on the historical tax rates of the past eighty years, we arrived at the same numbers presented in the Commission's proposal under the table Maximum Individual Income Tax Rates5 for the period 1990 to 2000.
3. Calendar versus Fiscal Year Measurement Period
We support the Commission's decision to require calendar year after-tax returns in the risk/return summary and fiscal year after-tax returns in the MDFP. Again, fund companies apply the Commission's formulas to calculate rates of return for many time periods beyond those required for regulatory compliance. In both types of after-tax returns, applying the historical tax rates in effect at the time of a distribution or at the time of redemption offers a highly extensible guideline that can be easily applied to any time period.
4. State and Local Tax Liability
We support the Commission's proposal to exclude the effect of state and local taxes in after-tax returns. This is a sensible way of creating a standard number that is applicable to as broad an audience as possible. A simple disclosure that the numbers do not include state and local taxes should suffice for regulatory reporting. However, we do believe that funds should be permitted to include state and local taxes in after-tax returns if their inclusion is disclosed, and if they are incorporated using the same standard formula outlined in the proposed rules.
5. Federal Alternative Minimum Tax and Phase-out Adjustments
We support the Commission's proposal to exclude the effect of the Alternative Minimum Tax and phase-out adjustments in after-tax returns. The AMT is a function of a multitude of variables that are highly idiosyncratic and cannot be usefully generalized to a calculation that is intended for use by all investors. Additionally, the application of the AMT would undermine the proposed rule's strength of revealing the maximum potential impact of taxes.
6. Timing and Method of Tax Payment
We support the Commission's proposal that the taxes due on a distribution are paid out of that distribution at the time the distribution is reinvested and reduces the amount reinvested. The approach is actually more robust than the intuitively attractive alternative of paying tax obligations on a fixed annual date such as December 31st or April 15th. Such alternative calculations introduce significant distortions by paying taxes on a different day than the tax obligation was incurred. Because the tax obligation is paid by selling shares the delay in time allows fluctuations in a fund's net asset value to change the actual impact of taxes on the returns. Although a delay might seem to better model individual investor behavior, the goal of the currently proposed pre-liquidation calculations (as well as our Rate of Return Net of Sales Charges) is to explicitly isolate the tax impact of portfolio manager decisions upon fund returns from investor decisions. Even in the post-liquidation returns where investor decisions are reflected, the alternatives increase the number of assumptions about investor decisions without increasing the correspondence of the results to individual investor outcomes. We feel that the Commission's proposal offers a robust solution that will be sustainable over time and extensible into returns for non-standard time periods.
7. Tax Treatment of Distributions
We agree with the Commission's proposal that distributions with distinctive tax characteristics should be broken out and treated according to the tax law in effect on the date of the distribution's reinvestment. This clear and simple rule can be extended easily as new tax categories emerge and the tax code changes over time. It also addresses present distribution characteristics such as:
Ordinary dividends
As the Commission has proposed, ordinary dividends should be reduced by the highest federal tax rate for ordinary income that was in effect at the time the distribution is reinvested.Capital Gain dividends
As the Commission has proposed, capital gains should be reduced by the highest federal tax rate for the appropriate category of capital gain (short, mid-term long, etc.) that was in effect at the time the distribution is reinvested.Foreign Tax Credits
Applying the principle of the proposed rule, foreign tax credits essentially function as taxes already paid. After a distribution has already been reduced by taxes as described above, any tax credit would be added back to the distribution before reinvestment.Return of Capital
Applying the principle of the proposed rule, return of capital should be free from taxation when a distribution is reinvested in a pre-liquidation after-tax rate of return. We also agree with the Commission's proposal that return of capital should reduce the cost basis of the investment for purposes of determining the taxable proceeds upon redemption in a post-liquidation rate of return.REIT income, Tax-free income and other special distributions
The proposed rule can be easily extended to these categories of distributions simply by applying the appropriate tax rate to each component of a distribution at the time of reinvestment. For example, under the current tax code the pass through of unrecaptured gains from a REIT would be reduced by 25%, while tax-free income would be reduced by 0%.
8. Capital Gains and Losses Upon a Sale of Fund Shares
We strongly support the Commission's proposal on this issue and believe that the proposed rule is not only correct, but that alternatives are false and misleading. We feel it is important to articulate the strength of the Commission's proposal on this issue, as well as demonstrate the serious risks of the proposed alternatives. The Commission's proposal appropriately requires that "post-liquidation after-tax returns be computed assuming a complete sale of fund shares at the end of the 1, 5, or 10-year measurement period, resulting in capital gains taxes or a tax benefit from any resulting capital losses. In computing the taxes from any gain or the tax benefit from any loss, the rate used would be required to correspond to the tax character of the capital gain or loss (e.g., short-term or long-term). The tax character of the capital gain or loss would be determined by the length of the measurement period (1, 5, or 10 years) in the case of the initial $1,000 investment and the length of the period between the reinvestment and the end of the measurement period in the case of reinvested distributions. 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."6
The first and most obvious argument in favor of the Commission's approach is simply that it is clearly correct. It accurately models the reality of how an investor's shares are taxed upon redemption of the shares. In addition to this unambiguous robustness, applying the appropriate tax rates that correspond to the actual time periods for which the initial investment and each reinvestment are held is highly extensible. Fund complexes can calculate year-to-date after-tax returns as easily as fund inception returns without concern that simplifying assumptions have reduced the numbers to a point of meaninglessness. Lastly, it is sustainable. As the structure of the tax code changes, applying the true tax rates will be a guiding principle that will ensure the calculations are relevant into the future.
The Commission asks if funds should be permitted to use a single capital gains rate for all gains or losses from a sale. This alternative would assume that reinvested distributions have the same holding period as the initial $1,000 investment. This alternative is not only a degradation in the accuracy and robustness of the calculation, but it also lacks the extensibility and sustainability of the rule that the Commission has proposed.
First, the resulting number would not be a post-liquidation rate of return; it would be a post-liquidation rate of return assuming there are not multiple capital gain rates that vary significantly and severely penalize your most recent gains. This is a grossly simplifying assumption. Rates of return are a measure of performance over time. A standard calculation that ignores the reality of the changing impact of taxes over time is frankly ignoring one of the most significant variables.
Not only does the alternative lack simple accuracy, but it also is not extensible. Since the inception of income taxes, the definition of a short, mid, and long-term capital gain has repeatedly changed. While the gain on an investment held for twelve months presently qualifies as a long-term, in 1997 the period extended to eighteen months. In 1984 the holding period was only six months, while it was nine months in 1977. In the 1930's the definition of a long-term capital gain varied between 24 months and 120 months! Since 1920 this definition has changed ten times; on average, the definition of a long-term capital gain changes every eight years. Consequently, the distortions introduced by applying a single capital gains rate to all holdings are not only dependent upon when the gains or losses in a fund occurred, but also upon the historical time period for which a return is being calculated. Ignoring the historical changes in the definition of a capital gain would be as damaging to the calculation results as ignoring the historical tax rates themselves.
For this same reason, the alternative of a single capital gains tax rate is not sustainable. The definition of the capital gains tax category will change over time causing unpredictable distortions of varying degree because of an unnecessary simplifying assumption. We strongly encourage the Commission to adopt its proposed rule. Put simply, the alternatives corrupt the calculations and would be a disservice to investors.
Conclusion
In conclusion, we strongly support the Commission's proposed rule for the calculation of after-tax returns. As we described above, we believe that the introduction of our alternative to the pre-liquidation rate of return will reduce the reporting requirement to fund companies while increasing its utility to investors and the industry. Additionally, we have reviewed and validated the excellent calculation assumptions proposed by the Commission. We hope that we have shown why the assumptions must be retained, and clearly illustrated the costly errors and inaccuracies that would result from abandoning them in favor of untenable alternatives. We strongly urge the Commission not to compromise the value of the proposed disclosure to investors.
To summarize the comments that we feel are most important we encourage the Commission to:
We greatly appreciate the opportunity to offer comment on the proposed rule. If you have any questions, or if we may be of any assistance during your review of these issues, please contact me at (412)-802-8632.
Sincerely,
Kirk Botula
Vice President
Confluence Technologies, Inc.
cc: Robert E. Plaze, Associate Director, Division of Investment Management
Susan Nash, Senior Assistant Director, Division of Investment Management
Footnotes
| 1 | SEC Proposed Rule: "Disclosure of Mutual Fund After-Tax Returns", File No. S7-09-00, Section II.A, March 15, 2000. |
| 2 | Proposed Rule, Section II.A. |
| 3 | Proposed Rule, Section II.A. |
| 4 | We have chosen to outline our comments so that they correspond directly to the outline of the proposed rule. Consequently, where there are topics upon which we have chosen not to comment there may be an apparent gap in the sequence of this document. |
| 5 | Proposed Rule, Section F.2. |
| 6 | Proposed Rule, Section II.F.8. |