CEF Investors Can't Expect Big Year-End Payouts

It looks as though closed-end fund investors, like bad little children, can expect only lumps of coal in their Xmas stockings this year -- and should trim their future expectations as well.

Most closed-end funds pay their shareholders monthly or quarterly distributions of "ordinary" income -- portfolio interest and dividends, net of expenses. However, many investors have come to anticipate an additional payout -- sometimes a large one -- around the end of each year. These mainly represent net capital gains realized on portfolio holdings during the year, which the tax code says must be distributed to shareholders annually.

This year the holiday season payouts will probably be very small or non-existent. It's still too early for funds to have long-term (>1 year) gains from the recent market rebound.

In addition, a special tax rule lets investment companies treat capital losses from sales in November and December as tho they occurred the following year, and we all remember that 11/08 and 12/08 were horrible months, filled with sellers' losses. This means that many closed-end funds will show net capital losses, not gains, when they calculate their year 2009 results, so year-end distributions will not be necessary.

Net capital losses get "carried forward" -- transferred to the following year's tax return, where they can offset an equal amount of capital gains. This means that the large net losses in 2008-2009 may also hang around to depress the calculation of distributable capital gains in year 2010 and beyond. (CEF loss carryforwards, unlike those of individuals, last for 8 years and then expire if not used.)

Some funds, such as those with "managed distribution" policies, may choose to make payouts to their shareholders anyway. This usually wouldn't be a problem as long as investors understand that "return of capital" distributions aren't "dividends" or "income" or "yield", but are simply partial refunds of the price they paid when they bought the shares. [A recent academic study concluded tho, that naive retail investors don't understand the difference and pay premium prices for the privilege of owning funds that hand the owners their own money back.]

And now, according to an article in last week's Tax Notes (the trade magazine for tax geeks) there is also a subtle technical trap when a fund with a capital loss carryover from the prior year decides to pay out the current year's capital gains rather than retaining them. The unexpected result is that the fund loses the benefit from the loss carryover, and the investor is taxed on the distribution using the rates that apply to ordinary income (max. 35%), not the much lower rates (max. 15%) currently in effect for tax-favored "qualified" dividends and long-term gains. Snap! Ouch!

That may well be the reason HQH and HQL recently discontinued their managed distribution policies. We can expect more funds to do the same.

Disclosure: Long HQH

Comments

[NUCLEAR1929:]

all they can get from santa is bag full of losses

Sep 07 10:31 AM

[Gruber:]

While I’m not an accountant and given that tax laws are not logical, since dollars are fungible, why wouldn’t a CEF that realized a capital gain in 2010 write it off against its 2009 capital losses and distribute the amount of capital gains anyway and designate it as a return of capital distribution?

It would seem to me that you’d get the best of both worlds? Remember we’re talking about cash flow and not earnings and profits.

Sep 07 11:02 AM

[Gwailo:]

This is a good question, and it merits a better answer than "That's the way it is." Here's my understanding of the analysis by Stephen Hamilton, Esq., in his recent article, which is available online at www.drinkerbiddle.com/...

Assume a CEF has a capital loss of $10 in year x1 and a capital gain of $10 in year x2, with all other items break-even. It nothing is paid out in year x2, the loss carryover simply cancels out the gain. But what happens if the CEF pays a year 2 distribution of $10 to its shareholders.

The $10 is a "dividend", as defined byTax Code Sec. 316(a), since it's covered by current ($10) *or* accumulated ($10-$10 = $0)
"Earnings and Profits". ("E&P" is a hybrid of tax and financial accounting concepts -- Code Sec. 312 has the gory details.)

CEFs can't make "return of capital" designations. "RoC" is a residual -- it's what left (if anything) after subtracting out the
"dividends" from the total amount distributed. Here $10 - $10 = $0, so no RoC.

Tax Code Sec. 852(b)(3) says CEF's can designate part or all of a dividend payment as a (long-term) "capital gain dividend", which gets favorable treatment (max 15% rate) on an individual investor's tax return. *However*, the amount that can be so designated is limited to the CEF's own "net capital gain" for the year, *after* subtracting any capital loss carryforwards. In our case, $10 - $10 = $0, so the CEF can't designate any of the $10 payout as a CGD.

Result: The $10 distributed in year x2 is a taxable dividend. It doesn't qualify for any special treatment, so it's "ordinary income", taxable for individual investors at marginal rates up to 35%. Snap! Ouch! The key to understanding the result is that the definition of "dividend" -- current *or* accumulated E&P -- doesn't count the year x1 loss, but that loss does get included when figuring the CEF's "net capital gains" for year x2.

'Gwailo

>"given that tax laws are not logical"

Oh, but they are. Very logical. The logic may be insane, but it's logic nonetheless. 'G

On Sep 07 11:02 AM Gruber wrote:

> While I’m not an accountant and given that tax laws are not logical, since dollars are fungible, why wouldn’t a CEF that realized a capital gain in 2010 write it off against its 2009 capital losses and distribute the amount of capital gains anyway and designate it as a return of capital distribution?
>
> It would seem to me that you’d get the best of both worlds? Remember we’re talking about cash flow and not earnings and profits.

Sep 07 02:15 PM

[Baboon:]

What confounds me is why the investors would prefer the realized capital gain distributions of cefs over the unrealized capital gains of plain-vanilla indexes ( given that their fees are significantly lower)?

Sep 07 06:28 PM

[bsharvy:]

I don't think CEF distributions are ever "qualified", since the CEF doesn't pay taxes on them. All of HQL's dividends for the last year have been "ordinary."

Sep 08 11:24 AM

[Gruber:]

Thank you for the detailed answer.

In your opinion, would this also be true for a special distribution with a different record date?

Thanks


On Sep 07 02:15 PM Gwailo wrote:

> This is a good question, and it merits a better answer than "That's
> the way it is." Here's my understanding of the analysis by Stephen
> Hamilton, Esq., in his recent article, which is available online
> at www.drinkerbiddle.com/...
>
>
> Assume a CEF has a capital loss of $10 in year x1 and a capital gain
> of $10 in year x2, with all other items break-even. It nothing is
> paid out in year x2, the loss carryover simply cancels out the gain.
> But what happens if the CEF pays a year 2 distribution of $10 to
> its shareholders.
>
> The $10 is a "dividend", as defined byTax Code Sec. 316(a), since
> it's covered by current ($10) *or* accumulated ($10-$10 = $0)
> "Earnings and Profits". ("E&P" is a hybrid of tax and financial
> accounting concepts -- Code Sec. 312 has the gory details.)
>
> CEFs can't make "return of capital" designations. "RoC" is a residual
> -- it's what left (if anything) after subtracting out the
> "dividends" from the total amount distributed. Here $10 - $10 = $0,
> so no RoC.
>
> Tax Code Sec. 852(b)(3) says CEF's can designate part or all of a
> dividend payment as a (long-term) "capital gain dividend", which
> gets favorable treatment (max 15% rate) on an individual investor's
> tax return. *However*, the amount that can be so designated is limited
> to the CEF's own "net capital gain" for the year, *after* subtracting
> any capital loss carryforwards. In our case, $10 - $10 = $0, so the
> CEF can't designate any of the $10 payout as a CGD.
>
> Result: The $10 distributed in year x2 is a taxable dividend. It
> doesn't qualify for any special treatment, so it's "ordinary income",
> taxable for individual investors at marginal rates up to 35%. Snap!
> Ouch! The key to understanding the result is that the definition
> of "dividend" -- current *or* accumulated E&P -- doesn't count
> the year x1 loss, but that loss does get included when figuring the
> CEF's "net capital gains" for year x2.
>
> 'Gwailo

Sep 08 04:11 PM

[Gwailo:]

Baboon: You're right, this is a case of investor irrationality caused by the way the choice is framed. Other things being equal, should an investor prefer (a) holding 100 shares of a fund that pays a $1/sh year-end taxable dividend and sees NAV & market price drop from $10/sh to $9, or (b) selling 10 shares and keeping 90 shares of a fund that pays no year-end dividend and has a NAV and market price of $10/sh.

I think a lot of folks would prefer (a), even tho in both cases the investor ends up with $100 cash and owns fund shares valued at $900. What's more, the dividend in (a) is fully taxable, while the investor would get to subtract the cost of the 10 shares sold in (b) in figuring gain or loss. The sale may feel like a more "permanent" reduction in ownership than the asset price/sh decrease in (a), even though the dollar amounts are the same.

Bsharvey: CEF's have a "pass-thru" tax regime: Code Sec. 854(b) says dividends paid by CEFs to investors are "qualified" to the extent the investment income of the CEF itself included qualified dividends, i.e. dividends paid by corporations that were taxed on their earnings.

HQH's operating expenses regularly exceed the dividends it receives. HQH is a capital gains play. For example, the 2008 annual report shows $2mm dividend income and $6 mm cost of operations, and the footnotes show that the @ $30mm HQH paid to investors for the year ending 9/30/08 was all treated as long-term gains.

>All of HQL's dividends for the last year have been "ordinary."

Please check the facts. The Statement of Changes to Net Assets in the HQH semi-annual report dated 3/31/09 shows year-to-date distributions of $14.7 million from net realized capital gains. A footnote explains that "A portion of the distributions from net realized capital gains for the six months ended March 31, 2009 may be deemed a tax return of capital at fiscal year end." That is, HQH can't finally characterize this year's distributions until it ends on 9/30/09.

'Gwailo ("Fact-checking is so last year.")

Sep 08 05:22 PM

[bsharvy:]

Yes, please check the facts. Dividends from CEF's are usually "ordinary" not "qualified." All HQL dividends last year were "ordinary." I own HQL; I pay attention.

Sep 10 09:22 PM

[Gwailo:]

> "All HQL dividends last year were 'ordinary.'"

HQL doesn't think so. See p. 19 of the annual report for y/ending 9/30/08: "The Fund has designated the following as long-term capital gain distributions for its taxable years ended September 30, 2008 and September 30, 2007. Distributions paid from Ordinary income $ — $ — Long-term capital gain $ 23,504,432 $ 22,280,388."

See also the Statement of Changes in the semi-annual report dated 3/31/09, saying that HQL had to date distributed $10,193,502 to shareholders from its net realized capital gains. A footnote explains that "(1) A portion of the distributions from net realized capital gains for the six months ended March 31, 2009 may be deemed a tax return of capital at fiscal year end."

Or check out HQL's schedule showing that the payouts were capital gains. www.hqcm.com/hql_distr...

'G ("You have the right to remain silent. Use it!")

Sep 11 06:49 AM