"Bailout" payments made by bank to its proprietary mutual funds must be capitalized.

• Author: Mangefrida, David

In a recent (not yet published) field service advice (FSA) memorandum, the IRS National Office advised that a bank acting as an investment adviser for its proprietary mutual funds was required to capitalize payments that the bank made to its money market funds to prevent the funds from falling below their targeted net asset values (NAVs). The FSA emphasized that the payments preserved the long-term benefits of the funds to the bank by sustaining its "core retail franchise" However, the FSA clearly suggests that the National Office may be generally predisposed to requiring capitalization of such payments, regardless of the particular circumstances surrounding the investment adviser or the payments.

Business Purpose of Bailout Payments

Although typically under no contractual obligation to do so, investment advisers occasionally infuse cash into a bond fund to return the fund to its targeted NAV. Investment advisers often make such payments (usually referred to as bailout payments) primarily to avoid potential shareholder litigation. In other contexts, investment advisers may similarly make "correction" payments to funds in connection with certain errors made to the detriment of the funds, such as tax return Preparation mistakes.

In the FSA, the taxpayer was a large commercial bank that served as the investment adviser for a family of proprietary mutual funds, including two money market funds that the taxpayer had acquired in a merger with another bank. Because of rising interest rates, the value of certain securities held by the money market funds declined, causing the NAV of each fund to fall below $1.00 per share (known as "breaking a dollar"). To eliminate the NAV deficiencies and return the funds to their targeted NAVs, the bank made bailout payments to the funds. It treated the bailout payments as currently deductible expenses, while the funds treated the payments as capital gains that offset the capital losses (causing the NAV deficiencies).

Risk Management Only One Consideration

Although the IRS noted that the taxpayer "was ... concerned about possible lawsuits by fund shareholders if the funds did `break a dollar' [i.e., fall below their targeted NAVs]" it concentrated on the other business purposes behind the taxpayer's establishment of proprietary mutual funds and the bailout payments. Specifically, the Service observed that the taxpayer offered the proprietary funds to preserve its customer base in an environment in Which market...