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Tax Insights, July 13, 2016
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July 13, 2016
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IRS and Treasury Issue Final Regulations on NAV Method of Accounting Relating to MMF Reform

The IRS and Treasury issued final regulations (TD 9774) under Sections 446 and 6045 (section references are to the Internal Revenue Code of 1986, as amended) providing a method of accounting for gain or loss on shares in a money market fund (MMF). The rules are intended to simplify tax compliance for holders of shares in MMFs affected by SEC regulations that impose liquidity fees or change how certain MMF shares are priced. The regulations also provide guidance regarding information reporting requirements for shares in MMFs.

The Treasury Department and the IRS published proposed regulations (REG-107012-14) on July 28, 2014, describing a simplified method of accounting for gain or loss on shares in a floating NAV (F-NAV) MMF (the net asset value method, or NAV method). Under the NAV method, a taxpayer’s gain or loss on shares in an MMF is based on the change in the aggregate value of the taxpayer’s shares during a computation period selected by the taxpayer and on the net amount of the purchases and redemptions during the computation period. The proposed regulations also provided guidance regarding information reporting requirements for shares in MMFs, revising Treasury Regulations Section 1.6045-1(c)(3)(vi). The Treasury Department and the IRS modified the proposed regulations regarding the NAV method, as further described below, and adopted the proposed regulations regarding information reporting without substantive change. The NAV method regulations apply to taxable years ending on or after July 8, 2016, and the information reporting regulations are applicable to sales of shares in calendar years beginning on or after July 1, 2016. However, taxpayers may rely on the proposed regulations for taxable years beginning before July 8, 2016, or for sales of shares in calendar years beginning before July 8, 2016.

Summary of Revisions

The IRS and Treasury received a number of comments in response to the proposed regulations and, as a result, have made revisions to proposed regulations as follows:

  • Taxpayers are permitted to apply the NAV method to shares in stable-NAV (S-NAV) MMFs.
  • MMF shareholders are permitted to use different methods of accounting for shares in different MMFs or for shares in a single MMF held in different accounts.
  • The NAV method is applicable for purposes of the computations required by Section 4982 (excise tax provisions applicable to regulated investment companies (RICs), and the taxable year for purposes of those computations is the relevant period under Section 4982(e)). The final regulations require, however, a RIC to be consistent in applying the NAV method to MMF shares for income tax and excise tax purposes. For each MMF in each account, the final regulations generally require a RIC to use the NAV method either for both income tax and excise tax computations or for neither computation, and the RIC must use the same computation periods for both excise tax and income tax computations. However, to provide more flexibility, the final regulations eliminate the requirement that computation periods be of approximately equal duration. The final regulations also clarify how a RIC may change to or from the NAV method.
  • The fair market value (FMV) of a share in an MMF at the time of a transaction is presumed to be the published NAV (or other published amount for which the MMF would redeem the share, determined without regard to any liquidity fees (other redemption amount)). For purposes of computing the ending value for a computation period, the presumption applies to the last published NAV (or other redemption amount) in that computation period.
  • The final regulations include provisions for determining the amount received for purposes of computing a taxpayer’s net investment in an MMF for a computation period. If the consideration received in exchange for an MMF share consists only of cash, other MMF shares or both, the amount received is the amount of any cash plus the FMV of any MMF shares received. If the consideration includes any property other than cash or MMF shares, the amount received is determined by reference to the FMV of the surrendered MMF shares.
  • The final regulations clarify the effect on net investment of a share acquired from another person with a transferred basis by providing that if a shareholder receives a transferred basis in one or more acquired MMF shares and the person from whom the shareholder acquired the shares used the NAV method, then the adjusted basis of the acquired shares will be their FMV at the time of the acquisition, which value is presumed to be the next NAV (or other redemption amount) published by the MMF.

The final regulations do not make any changes regarding MMF accounts with shares of a mixed character. The proposed regulations provide that if a taxpayer uses the NAV method for shares in an MMF and each of those shares otherwise would give rise to capital gain or loss if sold or exchanged in a computation period, then the gain or loss from the shares in the MMF is treated as capital gain or loss under the NAV method. Likewise, if each of the shares otherwise would give rise to ordinary gain or loss if sold or exchanged in a computation period, then the gain or loss is treated as ordinary gain or loss. If, however, the sale of all the shares in the MMF would give rise to a combination of ordinary gain or loss and capital gain or loss if sold or exchanged in a computation period, then all gain or loss from the shares in the MMF is treated as capital gain or loss.

The final regulations permit shareholders of S-NAV MMFs to use the NAV method. Because of this, the Treasury Department and IRS are not extending the exemption in Rev. Proc. 2014-45 to S-NAV MMFs as had been requested by commenters. (Revenue Procedure 2014-45 provides that the wash sale rules in Section 1091 are not applied to redemptions of shares in F-NAV MMFs.) 

The IRS and Treasury also received a comment requesting Treasury and the IRS to issue guidance (1) setting forth the proper tax treatment by an MMF of liquidity fees that the MMF imposes and (2) providing that if an MMF imposes liquidity fees and subsequently distributes to shareholders amounts that correspond to amounts that the MMF retained as liquidity fees, the MMF will be deemed to have sufficient earnings and profits to treat the distribution as a dividend. Since these requests were unrelated to the NAV method or to the information reporting provision in the proposed regulations, they were not addressed in the final regulations, but Treasury and the IRS might consider guidance on those questions in the future.

Detailed Explanation of Revisions

  1. Application of the NAV Method to S-NAV MMFs
    Under the proposed regulations, the NAV method would apply only to F-NAV MMF shares. In the preamble to the proposed regulations, the Treasury Department and the IRS requested comments regarding whether the NAV method should be a permissible method of accounting for S-NAV MMF shares. Although S-NAV MMFs seek to maintain constant share prices, there are circumstances in which shares in a S-NAV MMF will give rise to gain or loss. In limited circumstances, shares in an S-NAV MMF may be redeemed at a price other than the target price, such as when the MMF breaks the buck. In addition, an S-NAV MMF may impose liquidity fees, which will generally result in the realization of a loss by a redeeming shareholder. If the acquisition of other shares causes such a redemption to be a wash sale under Section 1091, Section 1091(d) generally causes the basis of the acquired shares to exceed the cost of the shares. Because the price of an S-NAV MMF share rarely changes, any disposition of those acquired, higher-basis shares will likely result in another loss, which also may be deferred by the wash sale rules. Therefore, even if a liquidity fee is in effect for only one redemption by a shareholder and the share price of the MMF remains constant, that fee may cause a difference between the basis and value of the shareholder’s MMF shares that persists indefinitely. Determining gain or loss and basis on each transaction in an S-NAV MMF, taking into account the wash sale rules, would impose significant burdens on shareholders under these circumstances. To eliminate those burdens, a shareholder might need to terminate the shareholder’s entire interest in the affected MMF (and not initiate a new position until after the end of the period described in Section 1091(a)).

    Commenters recommended that the NAV method be applicable not only to shares in F-NAV MMFs but also to shares in S-NAV MMFs. Shareholders of S-NAV MMFs may be retail shareholders (generally, individuals) who are likely to rely on the cost basis reporting provided by funds or brokers for their other mutual funds. Those individuals are unlikely to have the systems necessary to record gains and losses and to track wash sales and the resulting basis adjustments.

    The NAV method reduces the complexity, and any tax-based motivation to terminate investments in MMFs, that would result from the imposition of a liquidity fee by an S-NAV MMF. Under the NAV method, any loss that resulted from the imposition of a liquidity fee by an MMF would be determined for a shareholder’s entire interest in the MMF (or in an account) for the appropriate taxable year (or computation period) rather than for a single transaction. Therefore, the wash sale rules would not defer the loss. The NAV method also requires fewer and simpler computations than traditional accounting does, even if there are no wash sales. For the years after an MMF breaks the buck or imposes a liquidity fee, the NAV method simplifies record keeping, because the gain or loss for each year is based on changes in the NAV during that year. Therefore, the final regulations permit taxpayers to apply the NAV method to shares in S-NAV MMFs.
  2. Consistency Requirement
    The proposed regulations provided that if a taxpayer applies the NAV method to shares in any MMF for a taxable year, the taxpayer must apply the NAV method to its shares in all MMFs for which that method is permissible.

    Commenters requested that the final regulations permit taxpayers to apply different methods to shares in different MMFs or to shares in a single MMF held in different accounts since some taxpayers might receive sufficient information about their shares in certain MMFs to compute gain or loss realized on each transaction, thereby enabling those taxpayers to compute gain or loss realized on each transaction for those MMFs.

    Commenters also noted that taxpayers may hold shares in a single MMF through different kinds of accounts (for example, an account with a broker and an account with the MMF itself) and may receive different information for the different accounts. The commenters recommended, because of that possibility, that taxpayers be permitted to use different accounting methods for shares held in different accounts. Commenters also noted that many MMF shareholders will be large institutional investors, which might hold shares in the same MMF through separate accounts controlled by different divisions.

    As a result of these comments, the final regulations permit MMF shareholders to use different methods of accounting for shares in different MMFs or for shares in a single MMF held in different accounts.
  3. Choosing NAV Method Computation Periods for RIC Excise Tax Purposes
    Under the NAV method, computation periods are the periods that a taxpayer selects for computing gain and loss for an MMF. The proposed regulations provided that computation periods may be the taxpayer’s taxable year or a shorter period, provided that (i) computation periods are of approximately equal duration, (ii) every day during the taxable year falls within one, and only one, computation period and (iii) each computation period contains days from only one taxable year.

    Most RICs must pay an excise tax under Section 4982 if they do not make the required distribution described in Section 4982(b) for a calendar year (i.e., generally 98 percent of the RIC’s ordinary income for the calendar year, plus 98.2 percent of the RIC’s capital gain net income for the one-year period ending on Oct. 31 of the calendar year).

    A commenter requested clarification that a RIC that holds MMF shares may use the NAV method for excise tax computations. That commenter also requested that the Treasury Department and the IRS confirm that a RIC that uses the NAV method is permitted to use the one-year period from Nov. 1 to Oct. 31 as its computation period for excise tax purposes since RICs generally account for items that are marked to market using two different one-year periods for income tax and excise tax purposes. Under Section 4982(e)(2)(A), the term “capital gain net income” when used in Section 4982 is determined by treating the one-year period ending on Oct. 31 of any calendar year as the RIC’s taxable year.

    The final regulations make the NAV method applicable for purposes of the computations required by Section 4982, and the taxable year for purposes of those computations is the relevant period under Section 4982(e). The final regulations require, however, a RIC to be consistent in applying the NAV method to MMF shares for income tax and excise tax purposes. For each MMF in each account, the final regulations generally require a RIC to use the NAV method either for both income tax and excise tax computations or for neither computation. The final regulations also clarify how a RIC may change to or from the NAV method and include an example describing how a RIC bifurcates its Section 4982 period, described below.

    The final regulations require a RIC to use the same computation periods for purposes of both excise tax and income tax computations. Therefore, under the final regulations, a RIC using the NAV method for its shares in an MMF generally treats the one-year period for which gain or loss from the MMF would be included in the amount determined under Section 4982(e)(2) or (e)(6) (the Section 4982 period) like a taxable year in applying the NAV method to determine the RIC’s required distribution under Section 4982(b). The RIC, however, may not use the Section 4982 period as a computation period for excise tax purposes if the Section 4982 period contains days from more than one income tax year. (The Section 4982 period will contain days from only one income tax year if (i) the RIC has in effect a valid election under Section 4982(e)(4) or (ii) the RIC’s tax year ends on Oct. 31.) Instead, in this situation, the RIC must divide the Section 4982 period into at least two computation periods so that each computation period contains days from only one income tax year. Similarly, the RIC may not use its full income tax year as a computation period for income tax purposes if the year contains days from more than one Section 4982 period. These consistency requirements simplify and clarify the interaction of Sections 852(b) and 4982.

    The final regulations eliminate the requirement that computation periods be of approximately equal duration since the Treasury Department and the IRS do not believe this requirement is essential to the operation of the NAV method, and eliminating the requirement allows taxpayers more flexibility. In particular, permitting computation periods of unequal duration will reduce the burden on RICs of complying with the requirement of consistent computation periods for income and excise tax purposes. For example, a RIC that applies the NAV method to its shares in an MMF (held as a capital asset) and that has an income tax year ending on Jan. 31 may meet the consistency requirements with two computation periods of unequal duration — one ending on Jan. 31 and the other on Oct. 31. The RIC also may use additional computation periods ending on other dates, such as Dec. 31.
  4. Clarification of Certain Amounts
    A. FMV of MMF shares
    Under the proposed regulations, gain and loss under the NAV method is determined by reference to the FMV of MMF shares.

    Commenters requested that the Treasury Department and the IRS clarify that the FMV of an MMF share for this purpose is the NAV reported by the MMF. One commenter suggested that the FMV of a share in an MMF should be the published NAV as of the end of the relevant day (or the next trading day, if the day in question is not a trading day). Another commenter suggested that because MMFs may strike several NAVs throughout the day, the FMV should be the next published NAV after a transaction.

    In response to these comments, the final regulations clarify that the FMV of a share in an MMF at the time of a transaction is presumed to be the published NAV (or other published amount for which the MMF would redeem the share, determined without regard to any liquidity fees (other redemption amount)). For purposes of computing the ending value for a computation period, the presumption applies to the last published NAV (or other redemption amount) in that computation period. For purposes of determining the FMV of MMF shares surrendered or received in a redemption or exchange, the presumption generally applies to the NAV (or other redemption amount) used to determine the consideration received in the transaction, or if the consideration is not based on a published NAV (or other redemption amount), the first NAV (or other redemption amount) published for the MMF shares after the transaction. If no NAV (or other redemption amount) is published, or if facts and circumstances indicate that the NAV (or other redemption amount) does not represent the FMV of a share in the MMF, the FMV is determined on the basis of all the facts and circumstances.

    B. Aggregate amount received
    Under the proposed regulations, a taxpayer’s net investment in an MMF for a computation period generally is equal to the aggregate cost of shares in the MMF purchased during the computation period, minus the aggregate amount received during the computation period in redemption of shares in the MMF.

    A commenter suggested that the final regulations clarify that the aggregate amount received is based on the following: (i) if cash is received, the cash proceeds; (ii) if shares in another MMF are received, the published NAV of the shares received as of the end of the day on which the redemption or exchange occurs (or the next trading day, if the day in question is not a trading day); or (iii) if other noncash property is received, the NAV of the redeemed or exchanged shares as of the end of the day on which the redemption or exchange occurs (or the next trading day if the day in question is not a trading day, or if the fund will not publish a NAV on or after the end of the day on which the redemption or exchange occurs, the fund’s last published NAV).

    The final regulations include provisions for determining the amount received for purposes of computing a taxpayer’s net investment in an MMF for a computation period. If the consideration received in exchange for an MMF share consists only of cash, other MMF shares or both, the amount received is the amount of any cash plus the FMV of any MMF shares received. If the consideration includes any property other than cash or MMF shares, the amount received is determined by reference to the FMV of the surrendered MMF shares.

    C. Substituted basis
    Under the proposed regulations, a taxpayer’s net investment would increase if the taxpayer acquired any shares in an MMF other than by purchase during the computation period. In such cases, the net investment increases by the adjusted basis (for purposes of determining loss) of each such share immediately after its acquisition. The proposed regulations also provided that if that adjusted basis would be determined by reference to the basis of one or more shares in an MMF that are being disposed of by the taxpayer in a transaction in which gain or loss is not recognized (exchanged basis), then the basis of each such disposed share is treated as being the FMV of that share at the time of its disposition.

    A commenter noted that the proposed regulations do not address a situation in which the shareholder receives a transferred basis in MMF shares acquired from another person. The commenter suggested that in that situation, if the person from whom the shareholder acquired the shares used the NAV method, then the adjusted basis of the acquired shares should be treated as the published NAV applicable to the acquisition date.

    The final regulations clarify the effect on net investment of a share acquired from another person with a transferred basis by providing that if a shareholder receives a transferred basis in one or more acquired MMF shares and the person from whom the shareholder acquired the shares used the NAV method, then the adjusted basis of the acquired shares will be their FMV at the time of the acquisition, which value is presumed to be the next NAV (or other redemption amount) published by the MMF.
  5. MMF Accounts With Shares of Mixed Character
    The proposed regulations provide that if a taxpayer uses the NAV method for shares in an MMF and each of those shares otherwise would give rise to capital gain or loss if sold or exchanged in a computation period, then the gain or loss from the shares in the MMF is treated as capital gain or loss under the NAV method. Likewise, if each of the shares otherwise would give rise to ordinary gain or loss if sold or exchanged in a computation period, then the gain or loss is treated as ordinary gain or loss. If, however, the sale of all of the shares in the MMF would give rise to a combination of ordinary gain or loss and capital gain or loss if sold or exchanged in a computation period, then all gain or loss from the shares in the MMF is treated as capital gain or loss.

    A commenter noted that the proposed regulations do not explain why all gain or loss should be treated as capital in the case of an account containing MMF shares of mixed character. The commenter recommended that the character of gain or loss with respect to a mixed character account be bifurcated based on the portion of the shares that would generate gain or loss of each character.

    The Treasury Department and the IRS believe that it is rare for a shareholder to hold shares of a single MMF the disposition of which would produce a mix of ordinary income and capital gain. Under that circumstance, a taxpayer may use different accounts to preserve the character of the shares that would produce ordinary income and capital gain. The purpose of the NAV method is to provide an alternative to traditional accounting for taxpayers seeking simplicity. The rationale for offering a method solely for MMFs is that the value of MMFs fluctuates so little that simplicity is more important than tracking each individual gain or loss. A rule that bifurcates gain or loss based on the value of the shares in a single account, when those values may change during a computation period, would make the NAV method more complex. That additional complexity is not warranted in light of the rarity of the circumstance the proposed bifurcation would address and the ability of shareholders to prevent the treatment of all gain or loss as capital by using separate accounts. Therefore, the final regulations retain the simplifying rule for mixed-character accounts.
  6. Wash Sale Rules Exemption for S-NAV MMFs
    Concurrently with the release of the proposed regulations, the Treasury Department and the IRS released Revenue Procedure 2014-45 (2014-34 IRB 388), which provides that the wash sale rules in Section 1091 are not applied to redemptions of shares in F-NAV MMFs.

    Commenters requested that the wash sale exemption, which is limited to F-NAV MMFs, be extended to S-NAV MMFs that impose liquidity fees.

    The final regulations permit shareholders of S-NAV MMFs to use the NAV method. A shareholder who uses the NAV method would not require an exemption from the wash sale rules because under the NAV method, net gain or loss is determined for each computation period, and no gain or loss is determined for any particular redemption of a taxpayer’s shares in an MMF. Without a determination of loss for a particular redemption, that redemption does not implicate the wash sale rules. Because taxpayers may use the NAV method to prevent wash sales, the Treasury Department and IRS are not extending the exemption in Rev. Proc. 2014-45 to S-NAV MMFs.

IRS Provides Procedures to Obtain IRS’ Automatic Consent to Change To or From NAV Method of Accounting
A taxpayer may adopt the NAV method for shares in a F-NAV MMF by use of the method in the federal income tax return for the first taxable year in which both (1) the taxpayer holds shares in that MMF and (2) that MMF is a F-NAV MMF. The final regulations relating to the NAV method of accounting provide that a taxpayer seeking to change to or from the NAV method must secure the consent of the commissioner in accordance with Treasury Regulation Section 1.446- 1(e). Simultaneously with the publication of final regulations relating to the NAV method of accounting, the Treasury Department and the IRS issued Rev. Proc. 2016-39 (2016-30 IRB), which provides the procedures by which a taxpayer may obtain automatic consent to change to or from the NAV method for shares in an MMF.

In certain circumstances, Rev. Proc. 2016-39 permits taxpayers to change to the NAV method on a federal tax return without filing a Form 3115 (“Application for Change in Accounting Method”). This simplified procedure applies to a taxpayer that holds shares in an S-NAV MMF and wants to change to the NAV method for a taxable year if (1) the taxpayer has not used the NAV method for shares in the MMF for any taxable year prior to the year of change, and (2) prior to the beginning of the year of change, either (a) the taxpayer’s basis in each share of the MMF has been at all times equal to the MMF’s target share price, or (b) the taxpayer has not realized any gain or loss with respect to shares in the MMF. For certain other changes, Rev. Proc. 2016-39 provides automatic consent procedures that require a short Form 3115. For example, these automatic consent procedures apply to a taxpayer that (1) has adopted a realization method for shares in an F-NAV MMF and wants to change to the NAV method for shares in that MMF, or (2) has adopted the NAV method for shares in an F-NAV MMF and wants to change to a permissible realization method for shares in that MMF.

IRS Issues New Proposed Qualified Intermediary Withholding Agreement; Addresses Qualified Derivatives Dealers
The IRS issued Notice 2016-42 setting out a proposed qualified intermediary (QI) withholding agreement that revises and updates the current QI withholding agreement published in July 2014. The current QI agreement expires at the end of 2016. The revised QI withholding agreement updates the current agreement by providing more detailed procedures regarding how qualified intermediaries satisfy their compliance review obligations and sets out terms and requirements for QIs that want to act as qualified derivatives dealers with respect to transactions subject to Section 871(m) (dividend equivalent payments). The proposed QI withholding agreement, when finalized, would be effective beginning Jan. 1, 2017.

IRS Allows Alternative Basis Recovery for Contingent Payment Stock Sale
The IRS issued four nearly identical private rulings (Private Letter Rulings 201626009, 201626010, 201626011 and 201626012) addressing a merger in which shareholders of the target corporation were to be paid in installments tied to the acquiring corporation’s stock price, which dropped significantly in value after the sale. The taxpayers in each of the four PLRs timely submitted requests for rulings that they be allowed to use an alternative method of basis recovery, as provided under Treasury Regulation Section 15a.453-1(c)(7)(ii). The IRS allowed, in each ruling, the use of an alternative basis recovery method for the shareholders’ contingent installment payment sale because the original method, combined with the drop in the acquiring corporation’s stock price, would substantially and inappropriately defer recovery of basis.

IRS Issues Information Letter on Tax Consequences of Crowdfunding
The IRS issued Information Letter 2016-0036 explaining the tax treatment of crowdfunding by looking to general principles of income inclusion. Crowdfunding revenues generally are includible in income if they are not (1) loans that must be repaid, (2) capital contributed to an entity in exchange for an equity interest in the entity or (3) gifts made out of detached generosity and without any “quid pro quo.” A voluntary transfer without a quid pro quo is not necessarily a gift for federal income tax purposes. In addition, crowdfunding revenues must generally be included in income to the extent they are received for services rendered or are gains from the sale of property.

IRS Provides Overview of Inversion Transactions and Their Consequences
In a recently updated International Practice Unit titled Corporate Inversions – Overview of Major Issues, the IRS provided guidance to its auditors on when the anti-inversion provisions of Section 7874 apply and the consequences of an 80 percent and 60 percent inversion.

California Issues Guidance on Late Unclaimed Property Reports
In connection with California’s unclaimed property laws, the California state controller has provided guidance on how to report late properties. If a property should have been reported in a previous report cycle (a late property), holders may report on the current Holder Notice Report such a property in addition to properties they are timely reporting. There is no need to separate late properties by report year. Holders must send due diligence notices to owners with a property value of $50 or more before reporting these accounts to the State Controller’s Office. If a property should have already been reported, but it requires holder due diligence, the holder should mail the notice not less than six months before the property is reported. (SCO Unclaimed Property Division Holders Newsletter, Summer 2016, Vol. 9, Issue 2, 07/01/2016.)

Delaware Legislation Addresses ABLE Program and 529 Plans
Delaware legislation (L. 2016, H358 (c. 295), effective July 1, 2016 creates the Plans Management Board (Board) to administer the Delaware Achieving a Better Life Experience (ABLE) Savings Account Program, the Delaware College Investment Plan (a Section 529 college savings plan) and the Delaware Deferred Compensation Program. In addition, the legislation amends the ABLE program provisions to provide that in lieu of the development of a Delaware ABLE program, the Board is authorized to effect the ABLE program’s purpose by entering into a consortium, joint venture or contract with another state or states, or by assisting eligible individuals in Delaware in identifying and accessing ABLE programs established by other states. The legislation also amends the ABLE program provisions to conform the law with federal ABLE legislation, and makes technical corrections to the three programs’ provisions.

Information contained in this publication should not be construed as legal advice or opinion or as a substitute for the advice of counsel. The articles by these authors may have first appeared in other publications. The content provided is for educational and informational purposes for the use of clients and others who may be interested in the subject matter. We recommend that readers seek specific advice from counsel about particular matters of interest.

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