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Many closed-end funds are leveraged by the use of preferred stock, so that dividends paid will qualify under Subchapter M of the Internal Revenue Code for pass-through of the special tax status of the income earned on the fund’s investments. Typically, the stock carries a short-term variable rate set through frequent (7-day or 28-day) "Dutch auction" remarketings by a broker/dealer, and is not puttable by the holders to the fund. However, under the terms of the underlying stock issuance, the fund is required to redeem part or all of the stock to the extent the fund fails to maintain compliance with either SEC leverage requirements or more stringent tests required to maintain ratings assigned by independent rating agencies. Such stock is contingently redeemable and is not a "liability" under ASC 480-10. Refer to FG, PwC's accounting and financial reporting guide, Financing transactions for guidance on implementing ASC 480-10. Additionally, refer to FSP, PwC’s accounting and financial reporting guide, Financial statement presentation for presentation and disclosures that would be expected in financial statements of entities that have instruments that are within the scope of ASC 480-10.
Subsequent to the issuance of ASC 480-10-S99 by the SEC staff, the SEC Division of Investment Management issued an interpretive release stating that its provisions, as well as those of Accounting Series Release (ASR) 268, applied to preferred stock redeemable under the conditions described in the preceding paragraph. S-X 5-02.28 requires securities with redemption features that are not solely within the control of the issuer to be classified outside of permanent equity (an example includes the maintenance of asset coverage requirements associated with rating agency requirements for preferred stock). Accordingly, the SEC staff expects that such preferred stock will be classified in a "mezzanine" caption, outside of common shareholders’ equity, and not included in the "net assets" caption appearing on fund balance sheets. Similarly, the SEC expects dividends paid on preferred stock to be presented in the statement of operations, immediately following either the "net investment income" or "net increase/decrease in net assets from operations" captions. (Because it is possible that some preferred stock dividends could be paid from capital gains to avoid "disproportionate distributions" under the Internal Revenue Code, we prefer to present the dividends after "net increase/decrease in net assets from operations.") Similar presentation is expected in the statement of changes in net assets. ASC 480-10-S99 is used by most issuers of preferred shares to govern the treatment of preferred stock dividends as more like debt than equity; accordingly, most entities accrue the preferred share dividends ratably through the period. Since these are mezzanine securities, expense and net investment income ratios should be computed exclusive of net assets attributable to preferred stock; however, to the extent the mezzanine security does not constitute a ASC 480-10 liability, dividends paid on the preferred should not be considered an expense. Often, investment companies supplementally disclose expense ratios using average net assets including the liquidation preference of preferred shares (particularly because key expenses, such as management fees, are based on net assets applicable to both preferred and common shares), and net investment income ratios after dividend payments to preferred shareholders.
ASR 268 requires that preferred stock carried in a "mezzanine" be presented on the balance sheet at the proceeds raised at the time of offering less related offering costs, with an increase to the full redemption amount being charged to expense at the time the issuer enters into a redemption transaction. However, because investors in closed-end funds often consider net asset value per common share a key statistical measure, applying this accounting to closed-end funds arguably would result in an overstatement of residual equity available to common shareholders. Further, virtually all funds explicitly state in their offering prospectuses both for offerings of common and preferred stock that the cost of any issuance of preferred stock will be borne by the common shareholders (in effect as a "trade-off" for the additional "spread" they will capture from leverage). Accordingly, closed-end investment companies typically charge preferred stock offering costs against common shareholders’ paid-in capital immediately upon completion of the offering. The SEC staff, in their interpretive release, stated that they will not challenge this industry practice so long as a clear statement about how the cost burden falls is made in the offering documents.
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