NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 2012
1. Organization
Churchill Tax-Free Fund of Kentucky (the “Fund”), a non-diversified, open-end investment company, was organized in March, 1987 as a Massachusetts business trust and commenced operations on May 21, 1987. The Fund is authorized to issue an unlimited number of shares and, since its inception to April 1, 1996, offered only one class of shares. On that date, the Fund began offering two additional classes of shares, Class C and Class Y Shares. All shares outstanding prior to that date were designated as Class A Shares and are sold at net asset value plus a sales charge of varying size (depending upon a variety of factors) paid at the time of purchase and bear a distribution fee. Class C Shares are sold at net asset value with no sales charge payable at the time of purchase but with a level charge for service and distribution fees for six years thereafter. Class C Shares automatically convert to Class A Shares after six years. Class Y Shares are sold only through authorized financial institutions acting for investors in a fiduciary, advisory, agency, custodial or similar capacity, and are not offered directly to retail customers. Class Y Shares are sold at net asset value with no sales charge, no redemption fee, no contingent deferred sales charge (“CDSC”) and no distribution fee. On April 30, 1998, the Fund established Class I Shares which are offered and sold only through financial intermediaries and are not offered directly to retail customers. Class I Shares are sold at net asset value with no sales charge and no redemption fee or CDSC, although a financial intermediary may charge a fee for effecting a purchase or other transaction on behalf of its customers. Class I Shares carry a distribution and a service fee. All classes of shares represent interests in the same portfolio of investments and are identical as to rights and privileges but differ with respect to the effect of sales charges, the distribution and/or service fees borne by each class, expenses specific to each class, voting rights on matters affecting a single class and the exchange privileges of each class. On December 1, 2012, the Board of Trustees approved a change in the Fund’s fiscal year end from December to March.
2. Significant Accounting Policies
The following is a summary of significant accounting policies followed by the Fund in the preparation of its financial statements. The policies are in conformity with accounting principles generally accepted in the United States of America for investment companies.
a)
|
Portfolio valuation:
Municipal securities which have remaining maturities of more than 60 days are valued each business day based upon information provided by a nationally prominent independent pricing service and periodically verified through other pricing services. In the case of securities for which market quotations are readily available, securities are valued by the pricing service at the mean of bid and asked quotations. If a market quotation or a valuation from the pricing service is not readily available, the security is valued at fair value determined in good faith under procedures established by and under the general supervision of the Board of Trustees. Securities which mature in 60 days or less are generally valued at amortized cost if their term to maturity at purchase is 60 days or less, or by amortizing their unrealized appreciation or depreciation on the 61st day prior to maturity, if their term to maturity at purchase exceeds 60 days.
|
21 | Churchill Tax-Free Fund of Kentucky
CHURCHILL TAX-FREE FUND OF KENTUCKY
NOTES TO FINANCIAL STATEMENTS (continued)
DECEMBER 31, 2012
b)
|
Fair value measurements:
The Fund follows a fair value hierarchy that distinguishes between market data obtained from independent sources (observable inputs) and the Fund’s own market assumptions (unobservable inputs). These inputs are used in determining the value of the Fund’s investments and are summarized in the following fair value hierarchy:
Level 1 – Unadjusted quoted prices in active markets for identical assets or liabilities that the Fund has the ability to access.
|
Level 2 – Observable inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These inputs may include quoted prices for the identical instrument on an inactive market, prices for similar instruments, interest rates, prepayment speeds, credit risk, yield curves, default rates and similar data.
Level 3 – Unobservable inputs for the asset or liability, to the extent relevant observable inputs are not available, representing the Fund’s own assumptions about the assumptions a market participant would use in valuing the asset or liability, based on the best information available.
The inputs or methodology used for valuing securities are not an indication of the risk associated with investing in those securities.
The following is a summary of the valuation inputs, representing 100% of the Fund’s investments, used to value the Fund’s net assets as of December 31, 2012:
Valuation Inputs
|
|
|
Investments in Securities
|
|
Level 1 – Quoted Prices
|
|
$
|
—
|
|
Level 2 – Other Significant Observable
|
|
|
|
|
Inputs — Municipal Bonds*
|
|
|
269,019,238
|
|
Level 3 – Significant Unobservable Inputs
|
|
|
—
|
|
Total
|
|
$
|
269,019,238
|
|
* See schedule of investments for a detailed listing of securities.
c)
|
Subsequent events:
In preparing these financial statements, the Fund has evaluated events and transactions for potential recognition or disclosure through the date these financial statements were issued.
|
d)
|
Securities transactions and related investment income:
Securities transactions are recorded on the trade date. Realized gains and losses from securities transactions are reported on the identified cost basis. Interest income is recorded daily on the accrual basis and is adjusted for amortization of premium and accretion of original issue and market discount.
|
e)
|
Federal income taxes:
It is the policy of the Fund to continue to qualify as a regulated investment company by complying with the provisions of the Internal Revenue Code applicable to certain investment companies. The Fund intends to make distributions of
income and securities profits sufficient to relieve it from all, or substantially all, Federal income and excise taxes.
|
22 | Churchill Tax-Free Fund of Kentucky
CHURCHILL TAX-FREE FUND OF KENTUCKY
NOTES TO FINANCIAL STATEMENTS (continued)
DECEMBER 31, 2012
Management has reviewed the tax positions for each of the open tax years (2009-2011) or expected to be taken in the Fund’s 2012 tax returns and has concluded that there are no significant uncertain tax positions that would require recognition in the financial statements.
f)
|
Multiple class allocations:
All income, expenses (other than class-specific expenses), and realized and unrealized gains or losses are allocated daily to each class of shares based on the relative net assets of each class. Class-specific expenses, which include distribution and service fees and any other items that are specifically attributed to a particular class, are also charged directly to such class on a daily basis.
|
g)
|
Use of estimates:
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of increases and decreases in net assets from operations during the reporting period. Actual results could differ from those estimates.
|
h)
|
Reclassification of capital accounts:
Accounting principles generally accepted in the United States of America require that certain components of net assets relating to permanent differences be reclassified between financial and tax reporting. On December 31, 2012 the Fund increased undistributed net investment income by $641 and decreased additional paid-in capital by $641. These reclassifications had no effect on net assets or net asset value per share.
|
i)
|
Accounting pronouncement:
In December 2011, FASB (the “Financial Accounting Standards Board”) issued ASU (“Accounting Standards Update”) No. 2011-11 related to disclosures about offsetting assets and liabilities. The amendments in this ASU require an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of those arrangements on its financial position. The ASU is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The guidance requires retrospective application for all comparative periods presented.
Management is currently evaluating the impact this amendment may have on the Fund’s financial statements.
|
3. Fees and Related Party Transactions
a)
Management Arrangements:
Aquila Investment Management LLC (the “Manager”), a wholly-owned subsidiary of Aquila Management Corporation, the Fund’s founder and sponsor, serves as the Manager for the Fund under an Advisory and Administration Agreement with the Fund. Under the Advisory and Administration Agreement, the Manager provides all investment
management and administrative services to the Fund. The Manager’s services include providing the office of the Fund and all related services as well as managing relationships with all of the various support organizations to the Fund such as the shareholder servicing agent, custodian, legal counsel, fund accounting agent, auditors and distributor. For its services, the Manager is entitled to receive a fee which is payable monthly and computed as of the close of business each day at the annual rate of 0.40 of 1% on the Fund’s average net assets.
23 | Churchill Tax-Free Fund of Kentucky
CHURCHILL TAX-FREE FUND OF KENTUCKY
NOTES TO FINANCIAL STATEMENTS (continued)
DECEMBER 31, 2012
Under a Compliance Agreement with the Manager, the Manager is compensated by the Fund for Chief Compliance Officer related services provided to enable the Fund to comply with Rule 38a-1 of the Investment Company Act of 1940.
Specific details as to the nature and extent of the services provided by the Manager are more fully defined in the Fund’s Prospectus and Statement of Additional Information.
b)
Distribution and Service Fees:
The Fund has adopted a Distribution Plan (the “Plan”) pursuant to Rule 12b-1 (the “Rule”) under the Investment Company Act of 1940. Under one part of the Plan, with respect to Class A Shares, the Fund is authorized to make distribution fee payments to broker-dealers or others (“Qualified Recipients”) selected by Aquila Distributors, Inc. (the “Distributor”) including, but not limited to, any principal underwriter of the Fund, with which the Distributor has entered into written agreements contemplated by the Rule and which have rendered assistance in the distribution and/or retention of the Fund’s shares or servicing of shareholder accounts. The Fund makes payment of this distribution fee at the annual rate of 0.15% of the Fund’s average net assets represented by Class A Shares. For the year ended December 31, 2012, distribution fees on Class A Shares amounted to $314,707 of which the Distributor retained $10,586.
Under another part of the Plan, the Fund is authorized to make payments with respect to Class C Shares to Qualified Recipients which have rendered assistance in the distribution and/or retention of the Fund’s Class C shares or servicing of shareholder accounts. These payments are made at the annual rate of 0.75% of the Fund’s average net assets represented by Class C Shares and for the year ended December 31, 2012, amounted to $81,539. In addition, under a Shareholder Services Plan, the Fund is authorized to make service fee payments with respect to Class C Shares to Qualified
Recipients for providing personal services and/or maintenance of shareholder accounts.
These payments are made at the annual rate of 0.25% of the Fund’s average net assets represented by Class C Shares and for the year ended December 31, 2012, amounted to $27,180. The total of these payments with respect to Class C Shares amounted to $108,719 of which the Distributor retained $21,174.
Under another part of the Plan, the Fund is authorized to make payments with respect to Class I Shares to Qualified Recipients. Class I payments, under the Plan, may not exceed for any fiscal year of the Fund a rate (currently 0.20%), set from time to time by the Board of Trustees, of not more than 0.25% of the average annual net assets
represented by the Class I Shares. In addition, Class I has a Shareholder Services Plan under which it may pay service fees (currently 0.15%) of not more than 0.25% of the average annual net assets represented by Class I Shares. That is, the total payments under both plans will not exceed 0.50% of such net assets. For the year ended December 31, 2012, these payments were made at the average annual rate of 0.35% of such net assets and amounted to $25,378 of which $14,502 related to the Plan and $10,876 related to the Shareholder Services Plan.
24 | Churchill Tax-Free Fund of Kentucky
CHURCHILL TAX-FREE FUND OF KENTUCKY
NOTES TO FINANCIAL STATEMENTS (continued)
DECEMBER 31, 2012
Specific details about the Plans are more fully defined in the Fund’s Prospectus and Statement of Additional Information.
Under a Distribution Agreement, the Distributor serves as the exclusive distributor of the Fund’s shares. Through agreements between the Distributor and various brokerage and advisory firms (“intermediaries”), the Fund’s shares are sold primarily through the facilities of these intermediaries having offices within Kentucky, with the bulk of any sales commissions inuring to such intermediaries. For the the year ended December 31, 2012, total commissions on sales of Class A Shares amounted to $572,126 of which the Distributor received $47,874.
4. Purchases and Sales of Securities
During the the year ended December 31, 2012, purchases of securities and proceeds from the sales of securities aggregated $53,297,649 and $32,048,304, respectively.
At December 31, 2012, the aggregate tax cost for all securities was $250,448,507. At December 31, 2012, the aggregate gross unrealized appreciation for all securities in which there is an excess of value over tax cost amounted to $18,685,408 and aggregate gross unrealized depreciation for all securities in which there is an excess of tax cost over value amounted to $114,677 for a net unrealized appreciation of $18,570,731.
5. Portfolio Orientation
Since the Fund invests principally and may invest entirely in double tax-free municipal obligations of issuers within Kentucky, it is subject to possible risks associated with economic, political, or legal developments or industrial or regional matters specifically affecting Kentucky and whatever effects these may have upon Kentucky issuers’ ability to meet their obligations.
6. Expenses
The Fund has negotiated an expense offset arrangement with its custodian wherein it receives credit toward the reduction of custodian fees and other Fund expenses whenever there are uninvested cash balances. The Statement of Operations reflects the total expenses before any offset, the amount of offset and the net expenses.
25 | Churchill Tax-Free Fund of Kentucky
CHURCHILL TAX-FREE FUND OF KENTUCKY
NOTES TO FINANCIAL STATEMENTS (continued)
DECEMBER 31, 2012
7. Capital Share Transactions
Transactions in Capital Shares of the Fund were as follows:
|
|
Year Ended
|
|
|
Year Ended
|
|
|
|
December 31, 2012
|
|
|
December 31, 2011
|
|
|
|
Shares
|
|
|
Amount
|
|
|
Shares
|
|
|
Amount
|
|
Class A Shares:
|
|
|
|
|
|
|
|
|
|
|
|
|
Proceeds from shares sold
|
|
|
2,973,701
|
|
|
$
|
32,697,942
|
|
|
|
1,824,609
|
|
|
$
|
19,277,035
|
|
Reinvested distributions
|
|
|
318,731
|
|
|
|
3,504,972
|
|
|
|
325,789
|
|
|
|
3,428,267
|
|
Cost of shares redeemed
|
|
|
(1,906,698
|
)
|
|
|
(20,984,314
|
)
|
|
|
(1,956,032
|
)
|
|
|
(20,369,092
|
)
|
Net change
|
|
|
1,385,734
|
|
|
|
15,218,600
|
|
|
|
194,366
|
|
|
|
2,336,210
|
|
Class C Shares:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Proceeds from shares sold
|
|
|
383,020
|
|
|
|
4,212,313
|
|
|
|
236,851
|
|
|
|
2,512,229
|
|
Reinvested distributions
|
|
|
16,303
|
|
|
|
179,179
|
|
|
|
16,791
|
|
|
|
176,711
|
|
Cost of shares redeemed
|
|
|
(142,259
|
)
|
|
|
(1,564,065
|
)
|
|
|
(225,140
|
)
|
|
|
(2,376,054
|
)
|
Net change
|
|
|
257,064
|
|
|
|
2,827,427
|
|
|
|
28,502
|
|
|
|
312,886
|
|
Class I Shares:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Proceeds from shares sold
|
|
|
4,350
|
|
|
|
47,700
|
|
|
|
–
|
|
|
|
–
|
|
Reinvested distributions
|
|
|
20,003
|
|
|
|
220,021
|
|
|
|
25,000
|
|
|
|
262,539
|
|
Cost of shares redeemed
|
|
|
(5,330
|
)
|
|
|
(59,058
|
)
|
|
|
(100,439
|
)
|
|
|
(1,069,349
|
)
|
Net change
|
|
|
19,023
|
|
|
|
208,663
|
|
|
|
(75,439
|
)
|
|
|
(806,810
|
)
|
Class Y Shares:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Proceeds from shares sold
|
|
|
516,524
|
|
|
|
5,670,451
|
|
|
|
319,880
|
|
|
|
3,377,570
|
|
Reinvested distributions
|
|
|
8,349
|
|
|
|
92,092
|
|
|
|
7,140
|
|
|
|
75,083
|
|
Cost of shares redeemed
|
|
|
(426,153
|
)
|
|
|
(4,678,546
|
)
|
|
|
(1,204,352
|
)
|
|
|
(12,511,903
|
)
|
Net change
|
|
|
98,720
|
|
|
|
1,083,997
|
|
|
|
(877,332
|
)
|
|
|
(9,059,250
|
)
|
Total transactions in Fund
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
shares
|
|
|
1,760,541
|
|
|
$
|
19,338,687
|
|
|
|
(729,903
|
)
|
|
$
|
(7,216,964
|
)
|
8. Trustees’ Fees and Expenses
At December 31, 2012 there were 7 Trustees, one of whom is affiliated with the Manager and is not paid any fees. The total amount of Trustees’ service fees (for carrying out their responsibilities) and attendance fees paid during the year ended December 31, 2012 was $93,551. Attendance fees are paid to those in attendance at regularly scheduled quarterly Board Meetings and meetings of the independent Trustees held prior to each quarterly Board Meeting, as well as additional meetings (such as Audit, Nominating, Shareholder and special meetings). Trustees are reimbursed for their expenses such as travel, accommodations and meals incurred in connection with attendance at Board Meetings and at the Annual Meeting of Shareholders. For the the year ended December 31, 2012, such meeting-related expenses amounted to $26,337.
26 | Churchill Tax-Free Fund of Kentucky
CHURCHILL TAX-FREE FUND OF KENTUCKY
NOTES TO FINANCIAL STATEMENTS (continued)
DECEMBER 31, 2012
9. Securities Traded on a When-Issued Basis
The Fund may purchase or sell securities on a when-issued basis. When-issued transactions arise when securities are purchased or sold by the Fund with payment and delivery taking place in the future in order to secure what is considered to be an advantageous price and yield to the Fund at the time of entering into the transaction. Beginning on the date the Fund enters into a when-issued transaction, cash or other liquid securities are segregated in an amount equal to or greater than the value of the when-issued transaction. These transactions are subject to market fluctuations and their current value is determined in the same manner as for other securities.
10. Income Tax Information and Distributions
The Fund declares dividends daily from net investment income and makes payments monthly. Net realized capital gains, if any, are distributed annually and are taxable. Dividends and capital gains distributions are paid in additional shares at the net asset value per share, in cash, or in a combination of both, at the shareholder’s option.
The Fund intends to maintain, to the maximum extent possible, the tax-exempt status of interest payments received from portfolio municipal securities in order to allow dividends paid to shareholders from net investment income to be exempt from regular Federal and Commonwealth of Kentucky income taxes. Due to differences between financial statement reporting and Federal income tax reporting requirements, distributions made by the Fund may not be the same as the Fund’s net investment income, and/or net realized securities gains. Further, a small portion of the dividends may, under some circumstances, be subject to taxes at ordinary income and/or capital gain rates. For certain shareholders, some dividend income may, under some circumstances, be subject to the alternative minimum tax. As a result of the passage of the Regulated Investment Company Modernization Act of 2010 (“the Act”), losses incurred in this fiscal year and beyond retain their character as short-term or long-term, have no expiration date and are utilized before capital losses incurred prior to the enactment of the Act. At December 31, 2012, the Fund had capital loss carryforwards of $1,221,211 of which $112,779 expires in 2016, $175,082 expires in 2017 and $101,515 and $831,835 have no expiration and retain their character of short-term and long-term, respectively.
The tax character of distributions:
|
|
Year Ended December 31,
|
|
|
|
2012
|
|
|
2011
|
|
Net tax-exempt income
|
|
$
|
8,555,151
|
|
|
$
|
8,790,165
|
|
Taxable income
|
|
|
876
|
|
|
|
–
|
|
|
|
$
|
8,556,027
|
|
|
$
|
8,790,165
|
|
27 | Churchill Tax-Free Fund of Kentucky
CHURCHILL TAX-FREE FUND OF KENTUCKY
NOTES TO FINANCIAL STATEMENTS (continued)
DECEMBER 31, 2012
As of December 31, 2012, the components of distributable earnings on a tax basis were as follows:
Capital loss carry forward
|
|
$
|
(1,221,211
|
)
|
Unrealized appreciation
|
|
|
18,570,731
|
|
Undistributed tax-exempt income
|
|
|
380,980
|
|
Other temporary differences
|
|
|
(380,980
|
)
|
|
|
$
|
17,349,520
|
|
The difference between book basis and tax basis undistributed income is due to the timing difference in recognizing dividends paid.
11. Ongoing Development
Beginning in December 2007 the three major credit rating agencies (Standard & Poor’s, Moody’s and Fitch) downgraded or eliminated ratings of the municipal bond insurance companies due to loss of capital from investments in subprime mortgages. Only a few insurers are now deemed to be investment grade. Thus, while certain bonds have insurance, some are no longer rated based upon the ratings of their insurers. Furthermore, because the ability of many of the Fund’s insurers to pay claims has been downgraded, the protection of such insurance has been diminished, and there is no assurance that some of them may be relied upon for payment.
28 | Churchill Tax-Free Fund of Kentucky