PwC alternatives alert, April 3, 2009

Internal Revenue Code Section 475(f) election reminder: April 15, 2009 deadline approaching

April 15, 2009, is a critical day for fund managers to determine whether to make an election to mark-to-market securities or commodities for 2009 tax purposes. This election, which is available to traders in securities or commodities under Section 475(f) of the Internal Revenue Code, can provide significant tax benefits to funds and their investors in the right circumstances.

Given the current economic climate, many funds have large unrealized losses coming into 2009, or have suffered additional losses in 2009. Section 475(f) is an election which allows traders in securities or commodities to elect to mark to market their securities positions for tax purposes, and treats the gains and losses on these positions as ordinary gains and losses. In addition, Section 475(f) requires the cumulative difference between realization and mark-to-market (e.g., existing unrealized losses) to be brought into income/loss as ordinary, not capital.

Set forth below is a listing of some of the key advantages and disadvantages of making a Section 475(f) election. The application of Section 475(f) can be complex, and may not be recommended for all trading strategies or situations, however it should be considered and discussed with your PwC tax advisor before April 15 to assure that an opportunity is not missed.

Advantages for making a mark-to-market election for tax purposes:

Losses as ordinary trade or business losses rather than capital losses
Taxable income will generally equal book income, and most of the traditional book/tax differences such as straddles, wash sales and constructive sale limitations are eliminated
Tax allocations are easier since taxable income generally follows book income
Individual limited partners will have an ability to carry back net operating losses in excess of current income to the two preceding taxable years
From a practical perspective, elimination of complex bond calculations relating to original issue discount, market discount, and the need to bifurcate gains/losses on foreign denominated bonds for foreign exchange treatment since all gains/losses would be ordinary
Elimination of most reportable transactions analysis and disclosure
Tax accounting method changes that may result in tax benefits (i.e., unrealized losses accounted for in current year as ordinary, while gains are deferred over four years).

Disadvantages for making a mark-to-market election for tax purposes:

Acceleration of unrealized gains and losses at year end
Limited capital gain opportunities
Relative permanence of election which is difficult to revoke
Capital gains converted into ordinary income, thereby eliminating possibility of offsetting against short-term capital losses
Limited ability to carry forward prior capital losses.

Who can make the election?

Funds that are engaged in a trade or business as a trader in securities or commodities can make the mark-to-market election under Section 475(f). Whether someone is a "trader" versus "investor" is not currently defined in the Internal Revenue Code and is dependent upon the specific facts and circumstances surrounding the investment strategy. Once the mark-to-market election is made, there is a partially rebuttable presumption that all securities held by the electing trader are included in the mark-to-market portfolio. A trader may exclude securities that are not "held in connection" with its activities as a trader by identifying such securities on its books and records no later than the date that they are acquired, although as a practical matter carving out securities may prove difficult. Furthermore, the statute is unclear where the securities' connection to the trader activity changes over time. This issue may arise where a security becomes illiquid and moved into a side pocket, or an illiquid security like a private placement instrument becomes publicly traded.

How is the election made?

For existing trader funds, in order for the mark-to-market election to be effective for the 2009 calendar year, the fund must attach a statement to its U.S. federal income tax return or extension -- whichever one is filed on the original due date which is generally April 15, 2009. The election statement must include the following information:

The election being made
The first taxable year for which the election is effective
The trade or business for which the election is made

The electing trader must also file a completed Form 3115, requesting a change in method of accounting and reflecting the adjustment of prior year unrealized gain/losses. This Section 481(a) adjustment is taken into account over four years for a positive adjustment and one taxable year for a negative adjustment. Form 3115 is not included with the initial election, but must be attached to a timely filed U.S. federal income tax return, including extensions, and will receive automatic consent to change from the Internal Revenue Service, assuming that all other procedural aspects are satisfied.

How PwC can help

If you have questions regarding whether a Section 475(f) mark-to-market election is available to you and whether it is advisable to make such an election given your specific fact pattern, please contact your PwC tax advisor or one of the partners in our practice.