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