Financial Services Alert: Developments of Note

IRS Rules that Restorative Payments to a Money Market Fund to Avoid "Breaking the Buck" May Be Expensed

The IRS published a technical advice memorandum ("TAM"), Letter Ruling 200247007, permitting a mutual fund operator to expense payments it made to prevent certain money market funds it advised from "breaking the buck" (having their net asset values fall below $1 per share). In the particular case addressed by the TAM, a commercial bank was permitted to deduct payments it made to maintain the $1 net asset value of two of its proprietary money market funds because the bank's motivation in making the payments was primarily to protect, maintain and preserve its business, not to create long-term benefits for the funds.

The bank was the investment adviser to a number of proprietary mutual funds. An unexpected hike in interest rates caused the value of structured securities offered by U.S. government agencies held by two of its largest money market funds to decline in value. Significant shareholder redemptions required the fund to liquidate holdings at a loss. Within two months, both funds were in danger of breaking the buck. If the bank did nothing and permitted the funds to break the buck, it believed that its reputation and goodwill would be damaged and that it would be subject to lawsuits by fund shareholders. If it purchased troubled fund assets at par and held them to maturity, the bank worried that the transaction would become public and would subject the bank to even bigger losses if interest rates continued to rise, which could result in lawsuits by the bank's own shareholders. Therefore, the bank decided to make restorative payments to the funds in the aggregate amount of the funds' realized losses.

The funds treated the restorative payments as capital gains, offsetting the realized losses. The bank expensed the payments. In determining whether this treatment was acceptable or whether the payments should have been capitalized, the IRS focused on the motivation of the bank in making the payments. Based upon the facts in this case, the IRS found that the bank's primary motivation for the payments was to defend its existing business, not to create a long-term benefit, and so the bank was entitled to expense the cost.

Although the TAM applies only to the taxpayer to which it was addressed, it is indicative of IRS views on restorative payments by a money market fund's adviser designed to prevent a deviation in the fund's $1 net asset...