Dispute Over Accounting for B Share Commissions

The treatment of regulated investment company (RIC) "B share" commissions has been an ongoing area of controversy between RIC share distributors and the IRS. In March 2000, the Investment Company Institute (ICI) presented draft guidance to the Service to facilitate resolution of this issue.

In a typical B share arrangement, a distributor pays commissions to a person selling RIC shares, for which the distributor is to receive a distribution fee from the mutual fund and (in some cases) a contingent deferred sales (CDSC) charge from the investor in future years. The ICI proposed allowing the amortization of capitalized commissions via one of two accounting methods: the simplified recovery method or the CDSC tracking method.

Under the simplified recovery method, the distributor would capitalize the commissions paid or incurred on B shares and recover such costs by straight-line amortization over a 48-month period. Under the CDSC tracking method, the distributor would capitalize the commissions paid on B shares and recover them by straight-line amortization over the period a CDSC may be payable by the shareholder, subject to certain adjustments related to actual experience of share redemptions and the imposition of the CDSC.

Rev. Proc. 2000-38

Rev. Proc. 2000-38 generally requires mutual fund distributors to capitalize commissions paid on sales of B shares and amortize them pursuant to one of three accounting methods: the distribution-fee-period method, the five-year method or the useful-life method.

Under all three methods, the distributor capitalizes the commissions paid. Differences arise in the timing and method of the amortization of capitalized commissions. Under the distribution-fee-period method, the distributor amortizes the commissions ratably over the period fees are received from the fund under Rule 12b-1. Under the five-year method, capitalized commissions are amortized over five tax years. Under the useful-life method, a distributor ascertains a recovery period based on all the facts and circumstances and amortizes commissions over it.

For each method, commissions may be pooled using a half-year convention for pools based on the time of distribution of the underlying shares. A termination event (a sale, redemption or conversion into another class of the underlying shares) may be taken into account to accelerate basis recovery if the distributor is using the distribution-fee-period method, but not for purposes of the five-year method (unless the entire pool suffers a termination event). For a distributor using the useful-life method, a termination event (such as a redemption) may be taken into account only if the useful-life period is computed without regard to the termination event.

In effect, Rev. Proc. 2000-38 provides guidance very similar to that requested by the ICI, except that a five-year recovery period is allowed (rather than the requested four-year period). As such, Rev. Proc. 2000-38 appears to be a favorable development for RIC distributors.

Change in Accounting Method

Rev. Proc. 2000-38 treats an accounting method change for B share commissions by distributors to any one of the three methods set forth in the revenue procedure as an automatic accounting method change made on a "cut-off" basis; no Sec. 481(a) adjustment is required. Distributors can choose to implement one of the three new accounting methods either in the tax year that includes Jan. 1, 2001 or in a later tax year. If the change is made for the year that includes Jan. 1, 2001, Rev. Proc. 2000-38 governs; if the change is filed on or before April 2, 2001, it can be made even if the issue is under consideration by Examination or Appeals. If the change is made for a later year or filed after April 2, 2001, it will be made pursuant to Rev. Proc. 99-49, and thus may be precluded if the issue is under consideration by Examination or Appeals.

Audit Protection

Regardless of the timing of the implementation of the revenue procedure, the distributor will obtain audit protection for tax years before the change year. If a distributor complies with Rev. Proc. 2000-38 requirements, the IRS will not raise the treatment of distributor commissions as an issue in any tax year before the change year and, if the treatment of distributor commissions has already been raised as an issue in a tax year before the change year, the Service will not further pursue the matter.

From David Mangefrida, Washington, DC