One of the cardinal rules of mutual-fund investing is to read the prospectus. Funds bend over backward to lay out the investment strategy and potential risks. Anyone who reads the prospectus and marketing brochures of the $140 million Permanent Portfolio Treasury Bill Portfolio would think the fund is a great deal. Its strategy is to convert interest income into capital gains by retaining income instead of declaring daily dividends as most money-market funds do. This can save a bundle in taxes because the tax rate on income can be as high as 39.6%, while on long-term gains it's 28%. There's only one catch--and it's not in the prospectus: The strategy may be illegal.
Experts believe that a portion of the 1993 tax bill, now Section 1258(c) of the tax code, prohibits a mutual fund from turning income into capital gains. Those who have bought the fund since May, 1993, could run afoul of the Internal Revenue Service if they claim their earnings from the Permanent Portfolio T-bill fund as capital gains.
Terry Coxon, president of the Permanent Portfolio Family of Funds Inc., a Petaluma (Calif.) fund company with $280 million in assets, says there's no need to discuss the law in the prospectus because it's irrelevant. "I don't believe Section 1258 applies to us," Coxon said in a telephone interview on Jan. 10. The next day, Coxon said a new version of the prospectus, due in February, would alert investors to the new law. "We don't want to make a promise an investor is going to get capital gains," said Coxon, "but I do believe he will." BUSINESS WEEK, unaware of the change in the law, reported on the fund's strategy to save taxes in its Dec. 6 issue.
ON HOLD. Even though Permanent Portfolio will amend its prospectus, securities lawyers say it should have done so much sooner. "If there is a material risk that a law applies to a fund, the fund must let people know about it," notes Robert E. Plaze, assistant director of the Securities & Exchange Commission division that regulates mutual funds.
The few other funds that practice the conversion strategy reacted to the new law much sooner. Those funds were sold mainly to corporations and institutional investors, while Permanent Portfolio marketed to individuals. The Eaton Vance Short-Term Treasury Fund, for instance, issued a one-page supplement to its prospectus on May 11, 1993. Eaton Vance advised shareholders that a law had been proposed that could affect their investment in the fund and urged them to seek their own tax advice. "We talked about changing the strategy of the fund, but how can you do that until rules are clarified?" asks Michael B. Terry, the fund's manager. The law does not cover investments in such funds made on or before Apr. 30.
"I don't see how you can in all good conscience represent this [conversion] as a valid sort of fund," says Bruce R. Bent, president of the Reserve Fund, which runs a conversion fund. "The law is ambiguous." He says institutional investors stopped putting money in the fund.
Many think the conversion strategy is unambiguously dead. Treasury officials decline to comment, but several delivered speeches to legal and mutual-fund groups last year asserting that Section 1258 did apply to funds such as Permanent Portfolio's. Robert N. Gordon, president of Twenty-First Securities Corp., once a fan of such funds, advised his many corporate clients in August to avoid making new investments in the funds. "If there's anyone who wants to see them work, it's me," says Gordon, whose firm had at one point $500 million of its clients' money in these funds.
True, the new section in the tax code doesn't mention mutual funds. But it treats "conversion transactions," attempts to recharacterize ordinary income as capital gains, as fully taxable ordinary income. Tm be a "conversion transaction," a strategy must meet two tests. First, "substantially all of the taxpayer's expected return...is attributable to the time value of the taxpayer's net investment." Time value, say those who argue that the law applies, includes interest-earning investments such as T-bills. Coxon disagrees. "We don't know how much time the investor is going to spend in the fund," he says. "That and how much he earns is going to depend on interest rates."
LATE HIT. The second test is whether the strategy is "marketed or sold as producing capital gains" from a time-value investment. On that count, the law unquestionably applies to Permanent Portfolio. The literature the fund distributes describes how it turns ordinary income into capital gains and how, because of the lower tax bite, the investor ends up with more aftertax income. BUSINESS WEEK also called the fund's toll-free telephone number on Jan. 10 and asked how the fund works. The fund, the representative said, "in effect turns interest income into capital gains, which are not taxed until you take them out of the fund."
Coxon's view that the conversion strategy will survive is unlikely to prevail. From now on, any mutual fund that wants to produce capital gains will have to do it the old-fashioned way: earn it.