HR 4337, the Regulated Investment Company Modernization Act of 2009 (the Act, and effective date of the Act’s enactment, the date of enactment), was introduced in Congress on Dec. 16, 2009. The Act is helpful to RICs and their shareholders in a number of respects. Two noteworthy proposed changes include the repeal of the preferential dividend rule and the treatment of income from commodities and commodity-index derivatives as qualifying income. The Act’s proposals are described below:
Unlimited capital loss carry forward. Under present law, a regulated investment company (RIC or fund) is permitted to carry forward a net capital loss from any year as a short-term capital loss to offset its capital gains, if any, realized during the eight years following the year of the loss. Under the Act, a capital loss would carry forward indefinitely under rules similar to those that apply to individuals, including the retention of its character as either short term or long term, effective for taxable years beginning after the date of enactment. Such losses will continue to be subject to an annual limitation, however, if there is a more than 50 percent change of ownership of the fund.
90 percent “good income” test. Under present law, income from commodities is not qualifying income. The IRS has also ruled that income from commodity-index derivatives (e.g., swaps and futures) is not qualifying income. On the other hand, the IRS has ruled privately that income from certain commodity-linked notes and wholly-owned foreign subsidiaries is qualifying. In addition, Treasury has authority (which it has not exercised) to issue regulations to exclude from qualifying income any income from foreign currency gains that is not directly related to the fund’s principal business of investing in stock or securities, i.e., the fund’s investment in foreign currencies for speculative purposes. Under the Act, income from commodities and commodity-index derivatives would be qualifying income. The Act also repeals the IRS’ regulatory authority to exclude from qualifying income gains that are derived from the fund’s investment in foreign currencies for speculative purposes. These amendments are effective for taxable years beginning after the date of enactment.
Saving provisions for qualification failures:
- For asset diversification test failures. Under present law, a fund will not lose its status as a regulated investment company if it fails the asset diversification test because of fluctuations in value of portfolio securities, other than a discrepancy that “exists immediately after the acquisition of any security or other property and is wholly or partly the result of such acquisition.” But any such failures (other than for the first quarter of the RIC’s existence) can be cured under a 30-day grace period. However, it is not unusual for asset diversification issues to arise after the 30-day cure period, at which time there is no statutory remedy. The Act provides a special rule for de minimis asset test failures and a means by which a RIC can cure other asset test failures and pay a penalty tax. The de minimis rule applies if the failure is attributable to ownership of assets the total value of which do not exceed the lesser of: (1) one percent of the value of the RIC’s total assets at the end of the quarter; and (2) $10 million, in which case the fund has six months to cure the failure. For other asset test failures, due to reasonable cause and not willful neglect, the Act imposes a tax in an amount equal to the greater of: (1) $50,000; or (2) the amount determined by multiplying the highest rate of tax specified in Section 11 (currently 35 percent) by the net income generated during the period of asset test failure by the assets that caused the RIC to fail the asset test. Such other failures must be disclosed and cured within six months.
- For “good income” test failures. Under present law, there is no statutory remedy for failures to satisfy the qualifying income test. Under the Act, failure to satisfy the qualifying income test due to reasonable cause and not willful neglect are excused if the fund discloses the failure and pays a tax equal to the amount of nonqualifying income in excess of 10 percent of the fund’s gross income. For example, if a RIC has $90x of gross income from sources that are qualifying income and $15x of gross income from other sources, a tax of $5x is imposed [$15x - $10x ($90x/9) = $5x].
These amendments are effective for taxable years with respect to which the due date (determined with regard to any extensions) of the return for such taxable year is after the date of the enactment.
Reporting of dividends and distributions to shareholders: Under present law, the character of dividends and distributions – including net capital gains, exempt interest, foreign tax credits, qualified dividends, and, in the case of non-U.S. shareholders, interest-related and short-term capital gain dividends – must be designated in a written statement mailed to shareholders within 60 days following the close of the fund’s fiscal year, typically in the fund’s annual report to shareholders. In addition, funds must send shareholders Forms 1099 based on dividends and distributions paid during the calendar year, even though the character of a fund’s dividend and distributions cannot be determined until the fund’s fiscal year end. This can and does lead to errors in Form 1099 reporting.
- 60-day designation rule. The Act replaces this 60-day designation rule with a requirement to report the character of dividends and distributions in a written statement furnished to shareholders, which may be a Form 1099.
- Excess reported amounts. For fiscal year funds, the Act allows “excess reported amounts” to be taken into account by the fund in the portion of its fiscal year beginning after Dec. 31 to reduce the need to amend Forms 1099. For example, assume a RIC for its taxable year ending June 30, 20X2, makes quarterly distributions of $30,000 on Sept. 30, 20X1, Dec. 31, 20X1, March 31, 20X2, and June 30, 20X2, and reports the amounts as capital gain dividends. If the RIC has only $100,000 net capital gain for its taxable year, the excess reported amount is $20,000. Because the post-December reported amount ($60,000) exceeds the excess reported amount ($20,000), the excess reported amount is allocated among the post-December reported capital gain dividends in proportion to the amount of each such distribution reported as a capital gain dividend. Thus, one-half of the excess reported amount (i.e., 1/2 of $20,000 = $10,000) is allocated to each post-December distribution, reducing the amount of each post-December distribution treated as a capital gain dividend from $30,000 to $20,000. Because no excess reported amount is allocated to either of the quarterly distributions made on or before Dec. 31, 20X1, the entire $30,000 of each of the distributions retains its character as a capital gain dividend. In the event that the post-December reported amount does not exceed the excess reported amount, the excess reported amount will continue to be allocated among all the reported capital gain dividends for the taxable year.
- Muni-bond funds. Under present law, the current earnings and profits of a RIC are not reduced by amounts disallowed as deductions (interest expense and amortizable bond premium) in earning tax-exempt interest. If a muni-bond fund over distributes its income, the effect of this rule is to convert what would otherwise be a return of capital into an ordinary dividend. The Act fixes this problem by providing that the deductions disallowed in computing investment company taxable income relating to tax-exempt interest are allowed in computing current earnings and profits of a RIC.
- Pass-through of exempt-interest dividends and foreign tax credits by fund of funds. Under present law, a RIC that is a “fund of funds” can’t pass through to its shareholders exempt-interest dividends and foreign tax credits earned by lower-tier RICs. Under the Act, a qualified fund of funds is permitted to pass through to shareholders such items. A “qualified fund of funds” means a RIC at least 95 percent of the value of the total assets of which (at the close of each quarter of the taxable year) is represented by cash and cash items (including receivables) and interests in other RICs.
These amendments regarding the elimination of the 60-day designation rule and excess reported amounts are effective for distributions in taxable years beginning after the date of enactment. The provisions applying to earnings and profits and qualified fund of funds apply to taxable years beginning after the date of enactment.
Spillback dividends. Under present law, a spillback dividend (that is, a dividend paid after the close of a taxable year treated as paid during the taxable year) must be: (1) declared prior to the extended due date of return for the prior taxable year; (2) paid in the 12-month period following the close of the prior taxable year; and (3) paid no later than the date of the first regular dividend payment made after the declaration. When there is a failure to put the prior year’s return on extension, funds have been required to seek administrative relief from the IRS to pay a spillback dividend after the original due date of the return. The Act cures this problem by providing that the time for declaring a spillover dividend is the later of the 15th day of the ninth month following the close of the prior taxable year or the extended due date for filing the return. Also, the requirement that the distribution be paid not later than the date of the first regular dividend payment made after the declaration is amended (some might argue clarified) to state that the distribution be paid not later than the date of the first dividend payment of the same type (for example, an ordinary income dividend or a capital gain dividend) made after the declaration. These amendments are effective for distributions in taxable years beginning after the date of enactment.
Return of capital distributions. Under present law, a dividend is a distribution of property by a corporation out of its current or accumulated earnings and profits. A distribution in excess of earnings and profits is first treated as return of capital. Current earnings and profits are prorated among distributions made during the taxable year. This proration rule can have the effect of converting what would otherwise have been taxable dividends into a return of capital. The Act partially cures this problem by providing that in the case of a non-calendar-year RIC that makes distributions of property with respect to the taxable year in an amount in excess of the current and accumulated earnings and profits, the current earnings and profits are allocated first to distributions made on or before Dec. 31 of the taxable year. In the case of a RIC with more than one class of stock, the provision applies separately to each class of stock. This change should minimize the need to send shareholders amended Forms 1099 to report a return of capital during the portion of the RIC’s taxable year ending on Dec. 31. These changes are effective for distributions made in taxable years beginning after the date of enactment.
Distributions in Redemption of Stock of a RIC. Under present law, a redemption of stock by a corporation is treated as a sale or exchange if the redemption (1) is in complete termination of the shareholder’s interest, (2) is substantially disproportionate or (3) is not essentially equivalent to a dividend. In RIC-RIC master feeder and fund of funds structures, and in the case of RICs that are funding vehicles for separate accounts of insurance companies, it is not always clear whether distributions in redemption of stock in a lower-tier RIC should be treated as a sale or exchange or a dividend (with no basis offset). In addition, if the upper-tier RIC and lower-tier RIC are part of a controlled group, any loss by the upper-tier RIC on the disposition of the lower-tier RIC shares may be deferred. The Act provides that, except to the extent provided in regulations, the redemption of stock of a publicly offered RIC is treated as a sale or exchange if the redemption is upon the demand of the shareholder and the RIC issues only stock that is redeemable upon the demand of the shareholder. A “publicly offered RIC” is a RIC the shares of which are: (1) continuously offered pursuant to a public offering; (2) regularly traded on an established securities market; or (3) held by no fewer than 500 persons at all times during the taxable year. The Act also provides that, except to the extent provided in regulations, the loss deferral rule does not apply to any redemption of stock of a RIC if the RIC issues only stock that is redeemable upon the demand of the shareholder and the redemption is upon the demand of a shareholder that is another RIC. These amendments are effective for distributions after the date of enactment.
Repeal of preferential dividend rule for publicly offered RICs. Under present law, RICs are allowed a deduction for dividends paid to their shareholders, provided the dividend is not preferential. For this purpose, a dividend is preferential unless it is pro rata with no preference to any share of stock compared to other shares of the same class, and with no preference to one class as compared to another, except to the extent the class is entitled to a preference. Foot faults can easily arise in the context of multiple-class funds. The Act repeals the preferential dividend rule for publicly offered RICs as defined above, effective for distributions in taxable years beginning after the date of enactment. However, Section 18 of the Investment Company Act of 1940 will continue to impose restrictions on senior securities.
Coordination of excise tax distribution rules with those for income tax purposes: Under present law, there are a number of technical issues that arise for RICs in reconciling the distributions required for excise tax purposes with those required for income tax purposes. The Act remedies some of these technical issues.
- Elective deferral of certain late-year losses of RICs for income tax purposes. The Act provides that, except to the extent provided in regulations, a RIC may elect to “push” to the first day of the next taxable year part or all of any post-October capital loss. A “post-October capital loss” means the greatest of the RIC’s net capital loss, net long-term capital loss or net short-term capital loss (attributable to the portion of the taxable year after Oct. 31). The election applies for purposes of determining: (1) taxable income; (2) net capital gain; and (3) earnings and profits. The Act also provides that, except to the extent provided in regulations, a RIC may elect to “push” to the first day of the next taxable year part or all of any qualified late-year ordinary loss. A qualified late-year ordinary loss is the excess of : (1) the sum of the ordinary losses attributable to the portion of the taxable year after Dec. 31 and specified losses for the months of November and December over; and (2) the sum of the ordinary income attributable to the portion of the taxable year after Dec. 31 and specified gains for the months of November and December. These amendments are effective for taxable years beginning after the date of enactment.
- Expands list of exempt entities for exception from excise tax. Under present law, the 4 percent excise tax rules do not apply to a RIC for any calendar year if at all times during the calendar year each shareholder in the RIC is either a qualified pension plan or a segregated asset account of a life insurance company held in connection with variable contracts. The Act expands the type of tax-exempt entities that can hold shares of the RIC without it being subject to excise tax to conform to the list of permitted persons under the Section 817 diversification rules, including Roth IRAs, certain government plans described in Section 414(d) or 457, and a pension plan described in Section 501(c)(18). This amendment applies to calendar years beginning after the date of enactment.
- Deferral of certain gains and losses of RICs for excise tax purposes. Under the Act, the present-law excise tax “push” rules applicable to foreign currency gains and losses are expanded to include all “specified gains and losses,” i.e., ordinary gains and losses from the sale, exchange or other disposition of (or termination of a position with respect to) property, including foreign currency gain and loss, and amounts marked to market under the passive foreign investment company (PFIC) rules. These post-Oct. 31 gains and losses are “pushed” to the next calendar year. The present-law rule treating passive PFIC stock as disposed of on Oct. 31 is made applicable to all property held by a RIC that under any provision of the Code is treated as disposed of on the last day of the taxable year. The Act also allows a non-calendar-year RIC, except as provided in regulations, to elect to “push” any net ordinary loss to Jan. 1 to offset other income realized after Dec. 31. These amendments are effective for calendar years beginning after the date of enactment.
- Distributed amount for excise tax purposes. Under present law, a RIC is generally treated as having distributed amounts on which a tax is imposed on the RIC during the calendar year in which the taxable year of the RIC ends, regardless of the calendar year in which estimated tax payments are made (for instance, in the case of a RIC investing in muni bonds that chooses to pay tax on any market discount rather than pass through ordinary income to shareholders). The Act allows a RIC to increase the distributed amount for the calendar year by the amount on which the estimated tax payments are made during that calendar year. The distributed amount for the following calendar year is reduced by the amount of the prior year’s increase. This amendment is effective for calendar years beginning after the date of enactment.
Repeal of penalty on deficiency dividends. Under present law, a RIC making a deficiency dividend is subject to an interest charge as if the entire amount of the deficiency dividend were the amount of the tax deficiency. An additional penalty is also imposed. The Act repeals the additional penalty with respect to deficiency dividends for taxable years beginning after the date of enactment.
Modification of sale load basis deferral rule for RICs. The Act limits the applicability of the sales load basis deferral provision to cases where the taxpayer subsequently acquires stock before Jan. 31 of the calendar year following the calendar year the original stock is disposed of, effective for sales load charges incurred in taxable years beginning after the date of enactment.
The Act was referred to the House Ways and Means Committee on Dec. 16, 2009, which was only the first step in the legislative process. We will continue to monitor its progress and any related legislative proposals and, when necessary, publish additional guidance with respect to the proposed legislation.
You can access a summary of the Act at http://waysandmeans.house.gov/media/pdf/111/MA_Summary.pdf and the House Ways and Means Committee’s technical
explanation of the Act at http://waysandmeans.house.gov/media/pdf/111/RIC_Tech.pdf.
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