Notes to Financial Statements
November 30, 2013
1. Organization
The Cushing
®
Royalty & Income Fund (the “Fund”) was formed as a Delaware statutory trust on July 18,
2011, and is a
non-diversified,
closed-end
investment company under the Investment Company Act of 1940, as amended (the “1940 Act”). The Fund is managed by
Cushing
®
MLP Asset Management, LP (the “Adviser”). The Fund’s investment objective is to seek a
high total return with an emphasis on current income. The Fund commenced operations on February 28, 2012. The Fund’s shares are listed on the New York Stock Exchange under the symbol “SRF.”
2. Significant Accounting Policies
A. Use of Estimates
The preparation of financial statements in conformity with
U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, recognition of distribution income and disclosure of contingent assets and liabilities at
the date of the financial statements. Actual results could differ from those estimates.
B. Investment Valuation
The Fund uses the following valuation methods to determine fair value as either fair value for investments for which market quotations are available, or
if not available, the fair value, as determined in good faith pursuant to such policies and procedures as may be approved by the Fund’s Board of Trustees (“Board of Trustees”) from time to time. The valuation of the portfolio
securities of the Fund currently includes the following processes:
(i) The fair value of each security listed or
traded on any recognized securities exchange or automated quotation system will be the last reported sale price at the relevant valuation date on the composite tape or on the principal exchange on which such security is traded. If no sale is
reported on that date, the Adviser utilizes, when available, pricing quotations from principal market makers. Such quotations may be obtained from third-party pricing services or directly from investment brokers and dealers in the secondary market.
Generally, the Fund’s loan and bond positions are not traded on exchanges and consequently are valued based on market prices received from third-party services or broker-dealer sources.
(ii) Listed options on debt securities are valued at the average of the bid price and the ask price. Unlisted options on debt
or equity securities are valued based upon their composite bid prices if held long, or their composite ask prices if held short. Futures are valued at the last sale price on the commodities exchange on which they trade.
(iii) The Fund’s
non-marketable
investments will generally be valued in such
manner as the Adviser determines in good faith to reflect their fair values under procedures established by, and under the general supervision and responsibility of, the Board of Trustees. The pricing of all assets that are fair valued in this
manner will be subsequently reported to and ratified by the Board of Trustees.
The Fund may engage in short sale transactions. For financial
statement purposes, an amount equal to the settlement amount, if any, is included in the Statement of Assets and Liabilities as a liability. The amount of the liability is subsequently
marked-to-market
to reflect the current value of the short
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positions. Subsequent fluctuations in market prices of securities sold short may require purchasing the securities at prices which may differ from the market value reflected on the Statement of
Assets and Liabilities. When the Fund sells a security short, it must borrow the security sold short and deliver it to the broker-dealer through which it made the short sale. A gain, limited to the price at which the Fund sold the security short, or
a loss, unlimited in size, will be recognized under the termination of a short sale. The Fund is also subject to the risk that it may be unable to reacquire a security to terminate a short position except at a price substantially in excess of the
last quoted price. The Fund is liable for any dividends paid on securities sold short and such amounts would be reflected as dividend expense in the Statement of Operations. The Fund’s obligation to replace the borrowed security will be secured
by collateral deposited with the broker-dealer. The Fund also will be required to segregate similar collateral to the extent, if any, necessary so that the value of both collateral amounts in the aggregate is at all times equal to at least 100% of
the fair value of the securities sold short. The Fund did not hold any securities sold short at November 30, 2013.
C. Security
Transactions, Investment Income and Expenses
Security transactions are accounted for on the date securities are purchased or sold (trade
date). Realized gains and losses are reported on a specific identified cost basis. Interest income is recognized on the accrual basis, including amortization of premiums and accretion of discounts. Distributions are recorded on the
ex-dividend
date. Distributions received from the Fund’s investments in energy-related U.S. royalty trusts and Canadian royalty trusts and exploration and production companies (collectively, “Energy
Trusts”) and master limited partnerships (“MLPs”) generally are comprised of ordinary income, capital gains and return of capital from the Energy Trusts or MLPs. The Fund records investment income on the
ex-date
of the distributions. For financial statement purposes, the Fund uses return of capital and income estimates to allocate the dividend income received. Such estimates are based on historical information
available from each Energy Trust, MLP and other industry sources. These estimates may subsequently be revised based on information received from Energy Trusts or MLPs after their tax reporting periods are concluded, as the actual character of these
distributions is not known until after the fiscal year end of the Fund.
The Fund estimates the allocation of investment income and return of
capital for the distributions received from Energy Trusts and MLPs within the Statement of Operations. For the fiscal year ended November 30, 2013, the Fund has estimated approximately 17% of the distributions received from Energy Trusts and MLPs to
be from investment income with the remaining balance to be return of capital.
Expenses are recorded on the accrual basis.
D. Distributions to Stockholders
Distributions to common stockholders are recorded on the
ex-dividend
date. The character of distributions to common stockholders made during the year may differ
from their ultimate characterization for federal income tax purposes. For the fiscal year ended November 30, 2013, the Fund’s distributions were expected to be comprised of 100% return of capital. The tax character of distributions paid
for the fiscal year ended November 30, 2013 will be determined in early 2014.
E. Federal Income Taxation
The Fund, taxed as a corporation, is obligated to pay federal and state income tax on its taxable income. Currently, the maximum marginal regular federal
income tax rate for a corporation is 35%. The Fund may be subject to a 20% federal alternative minimum tax on its federal alternative minimum taxable income to the extent that its alternative minimum tax exceeds its regular federal income tax.
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The Fund invests its assets primarily in Energy Trusts and MLPs.
U.S. royalty trusts are generally not subject to U.S. federal corporate income taxation at the trust or entity level. Instead, each unitholder of the U.S.
royalty trust is required to take into account its share of all items of the U.S. royalty trust’s income, gain, loss, deduction and expense. It is possible that the Fund’s share of taxable income from a U.S. royalty trust may exceed the
cash actually distributed to it from the U.S. royalty trust in a given year. In such a case, the Fund will have less
after-tax
cash available for distribution to shareholders.
Canadian royalty trusts are taxed as regular Canadian corporations and are now subject to “double taxation” at both the corporate level and on
the income distributed to investors.
MLPs are generally treated as partnerships for federal income tax purposes. As a limited partner in MLPs,
the Fund reports its allocable share of each MLP’s taxable income in computing its own taxable income.
The Fund’s tax expense or
benefit is included in the Statement of Operations based on the component of income or gains (losses) to which such expense or benefit relates. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts
of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance is recognized if, based on the weight of available evidence, it is more likely than not that some portion or all of the
deferred income tax asset will not be realized.
The Fund recognizes in the financial statements the impact of a tax position, if that position
is more-likely-than-not to be sustained on examination by the taxing authorities, based on the technical merits of the position. Tax benefits resulting from such a position are measured as the amount that has a greater than fifty percent likelihood
on a cumulative basis to be sustained on examination.
F. Cash and Cash Equivalents
The Fund considers all highly liquid investments purchased with initial maturity equal to or less than three months to be cash equivalents.
G. Cash Flow Information
The
Fund makes distributions from investments, which include the amount received as cash distributions from Energy Trusts, MLPs, common stock dividends and interest payments. These activities are reported in the Statement of Changes in Net Assets, and
additional information on cash receipts and payments is presented in the Statement of Cash Flows.
H. Indemnifications
Under the Fund’s organizational documents, its officers and trustees are indemnified against certain liabilities arising out of the
performance of their duties to the Fund. In addition, in the normal course of business, the Fund may enter into contracts that provide general indemnification to other parties. The Fund’s maximum exposure under such indemnification arrangements
is unknown, as this would involve future claims that may be made against the Fund that have not yet occurred, and may not occur. However, the Fund has not had prior claims or losses pursuant to these contracts and expects the risk of loss to be
remote.
I. Offering Costs
At-the-market offering costs related to the issuance of common stock are charged to additional paid-in capital when the stock is issued. Offering costs of $4,793 were charged to additional paid-in capital
for the issuance of common stock in 2013.
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J. Recent Accounting Pronouncement
In December 2011, Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-11 “Balance Sheet (Topic 210) Disclosures about Offsetting Assets
and Liabilities”. ASU 2011-11 requires new disclosures for recognized financial instruments and derivative instruments that are either offset on the balance sheet in accordance with the offsetting guidance in ASC 210-20-45 or ASC 815-10-45 or
are subject to an enforceable master netting arrangement or similar arrangement. ASU 2011-11 is effective for periods beginning on or after January 1, 2013 and must be applied retrospectively.
In January 2013, the Financial Accounting Standards Board issued Accounting Standards Update No. 2013-01 “Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities”
(“ASU
2013-01”)
which amended Accounting Standards Codification Subtopic 210-20, Balance Sheet Offsetting. ASU 2013-01 clarified the scope of ASU No. 2011-11 “Disclosures about Offsetting Assets
and Liabilities” (“ASU 2011-11”). ASU 2013-01 clarifies the scope of ASU 2011-11 as applying to derivatives accounted for in accordance with Topic 815, Derivative and Hedging, including bifurcated embedded derivatives, repurchase
agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are offset either in accordance with other requirements of U.S. GAAP or subject to an enforceable master netting arrangement or similar
agreement. The guidance in ASU 2013-01 and ASU 2011-11 is effective for interim and annual periods beginning on or after January 1, 2013. Adoption of ASU 2011-11 will have no effect on the Fund’s net assets. Management has evaluated ASU
2013-01
and ASU 2011-11 and determined that there is no impact to the Fund’s financial statements.
3. Concentrations of Risk
The Fund’s investment objective is to seek a high total return with an emphasis on current income. The Fund will seek to achieve its investment objective by investing, under normal market conditions,
at least 80% of its net assets, plus any borrowings for investment purposes, in public and private securities of Energy Trusts, exploration and production MLPs and securities of other companies based in North America that are generally engaged in
the same lines of business as those in which Energy Trusts and MLPs engage (“Other Energy Companies”, and together with Energy Trusts and MLPs, “Energy Companies”); up to 25% of its Managed Assets in unregistered or otherwise
restricted securities, including securities issued by private companies; up to 25% of its Managed Assets in debt securities, preferred shares and convertible securities of Energy Companies and other issuers, provided that such securities are
(a) rated, at the time of investment, at least (i) B3 by Moody’s Investors Service, Inc. (“Moody’s”), (ii) B – by Standard & Poor’s (“S&P”) or Fitch Ratings
(“Fitch”), or (iii) of a comparable rating by another Nationally Recognized Statistical Rating Organization (“NRSRO”) or (b) with respect to up to 10% of its Managed Assets in debt securities, preferred shares and
convertible securities that have lower ratings or are unrated at the time of investment; and up to 20% of its Managed Assets in securities of companies that are not Energy Companies. These investments may include securities such as partnership
interests, limited liability company interests or units, trust units, common stock, preferred stock, convertible securities, warrants and depositary receipts and debt securities. The Fund will not invest directly in commodities.
“Managed Assets” means the total assets of the Fund, minus all accrued expenses incurred in the normal course of operations other than
liabilities or obligations attributable to investment leverage, including, without limitation, investment leverage obtained through (i) indebtedness of any type (including, without limitation, borrowing through a credit facility or the issuance
of debt securities), (ii) the issuance of shares of preferred stock or other similar preference securities and/or (iii) the reinvestment of collateral received for securities loaned in accordance with the Fund’s investment objective
and policies.
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4. Agreements and Related Party Transactions
The Fund has entered into an Investment Management Agreement with the Adviser (the “Agreement”). Under the terms of the Agreement, the Fund will
pay the Advisor a fee, payable at the end of each calendar month, at an annual rate equal to 1.50% of the average weekly value of the Fund’s managed assets during such month for the services and facilities provided by the Adviser to the Fund.
The Adviser earned $3,194,757 in advisory fees for the fiscal year ended November 30, 2013. The Adviser agreed to waive 0.25% of its management fee through February 28, 2013. The Adviser waived $132,717 for the fiscal year ended November 30,
2013.
The Fund has engaged U.S. Bancorp Fund Services, LLC to serve as the Fund’s administrator. The Fund pays the administrator a
monthly fee computed at an annual rate of 0.09% of the first $100,000,000 of the Fund’s average daily net assets, 0.07% on the next $200,000,000 of average daily net assets and 0.04% on the balance of the Fund’s average daily net assets,
with a minimum annual fee of $70,000.
U.S. Bancorp Fund Services, LLC serves as the Fund’s transfer agent, dividend paying agent, and
agent for the automatic dividend reinvestment plan.
U.S. Bank, N.A. serves as the Fund’s custodian. The Fund pays the custodian a monthly
fee computed at an annual rate of 0.004% of the Fund’s average daily market value, with a minimum annual fee of $4,800.
5. Income Taxes
Deferred income taxes reflect the net tax effect of temporary differences between the carrying amount of assets and liabilities for financial reporting
and tax purposes. Components of the Fund’s deferred tax assets and liabilities as of November 30, 2013, are as follows: