In a declining market, unrealized losses should theoretically generate deferred tax assets (DTAs) in C-corp funds. However, accounting rules make it difficult for mutual funds to support net DTAs, since they are not operating companies, and many funds are not allowed by their auditors to book the entirety of the DTA. Due to the 21 percent corporate tax rate, over a full cycle, many C-corp funds with net DTLs may capture only 79 percent of the market’s upside and most, if not all, of its downside.
Exhibit 3 shows how the taxes paid due to DTLs on unrealized gains may reduce a C-corp fund shareholder’s NAV by 21 percent. For an individual in the top tax bracket, selling the investment could potentially result in a total tax rate of as much as 37 percent, compared with 20 percent for a RIC fund.
RIC funds are not taxable entities and thus do not accrue DTLs from unrealized gains. Instead, income and realized net long-term capital gains pass through the RIC to the investor. As a result, RIC fund expense ratios do not include tax adjustments. A RIC fund investor is only taxed on realized income and capital gains, allowing them to keep more of what they earn.
The RIC Advantage
We view RIC funds as superior total return investments and C-corp funds primarily as income vehicles. By investing more broadly across the midstream universe, RIC funds have historically achieved better returns with only slightly greater volatility than the more MLP-focused C-corp fund universe.
In our view, the current environment of improving midstream energy industry fundamentals and rising interest rates is likely to favor total return strategies over income—and consequently, RICs over C-corps.
Tyler Rosenlicht, senior vice president, is a portfolio manager for Cohen & Steers' infrastructure portfolios with an emphasis on MLP and midstream energy strategies.