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CEF Specialist

Evaluating Tax Liabilities in Closed-End Funds

A walk-through for calculating accrued tax liabilities.

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Last Friday we talked about how undistributed net investment income, or UNII, creates a tax liability in closed-end funds. This week we take the analysis a bit further to see how the combination of UNII and unrealized capital gains can create tax liabilities in CEFs. By our estimates, nearly 550 CEFs currently have accrued tax liabilities of some sort, though many of them work out to less than 1% of net assets. For the sake of this analysis, let's walk through how to estimate the accrued tax liability of Western Asset Global High Income (EHI) as an example. This fund's liability is not particularly high; we chose it because the evaluation is relatively straightforward.

The November 2012 semiannual report lists UNII at $0.4286 per share. Because this is not the annual report, it's only an estimate on the fund's part. Considering that the May 2012 annual report lists UNII at $0.4423, and Western Asset estimates that the fund underearned its distribution by a slim margin over the six-month intervening period, the first number is likely a good estimate. Assuming that the fund underearned its distribution at the same rate over the previous three months, we can adjust it downward to an estimate of about $0.4200 per share. If the fund made a year-end distribution, we would account for this as well. Year-end distributions can often be a significant factor. PIMCO Income Opportunity (PKO), for example, nearly distributed the entirety of its UNII balance at 2012 year-end.

Steven Pikelny does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.