On Sept. 28, 2010, the U.S. House of Representatives in a surprise move approved H.R. 4337, renamed The Regulated Investment Company Modernization Act of 2010 (the Act). The Act is helpful to the taxation of regulated investment companies (RICs) and their shareholders in a number of respects.¹ The focus of this update is on the proposed modification of RIC qualifying income to include income from commodities and the substantive differences between the Act as originally proposed and the version of the Act as passed by the House.

Investment in Commodities. Of particular note, the Act modifies the definition of qualifying income for regulated investment companies in Section 851(b)(2) of the Internal Revenue Code of 1986, as amended (the Code), to include gross income derived from gains from the sale or other disposition of commodities or other income derived with respect to its business of investing in such commodities.² As a result, income earned by a RIC from an investment in commodities or derivative contracts with respect to a commodity or commodity index will be qualifying income for purposes of the gross income test. If enacted, this provision is effective for taxable years beginning after the date of enactment.

The Act also repeals the regulatory authority given to the Secretary of the Treasury to exclude certain foreign currency gains from qualifying income because the provision allows RICs to derive qualifying income from investments in commodities, which include foreign currencies.

A few observations:

• Neither the Act, Subchapter M of the Code nor the Investment Company Act of 1940 (1940 Act) appear to define the term commodity. However, the term commodity is used in the Code in other contexts. For instance, Code Section 864(b)(2)(B) states such term means commodities of a kind customarily dealt in on an organized commodity exchange.³
  
  
• The Act does not allow a RIC to be 100 percent invested in commodities (e.g., gold). This is because a RIC’s direct investment in commodities must be limited to less than 50 percent of the value of its total assets in order to satisfy the 50 percent prong of the asset diversification test of Code Section 851(b)(3).⁴ In this connection, however, certain derivatives on commodities (e.g., an exchange-traded note the return on which references a commodity index) may be a security under the 1940 Act and thus, by reference, a security for purposes of the RIC asset diversification test.
  
  
• The Act, when passed, would likely make the use of an offshore subsidiary (e.g., a Cayman Islands company wholly-owned by the investing RIC and classified as a controlled foreign corporation) to gain exposure to commodities unnecessary, although this requires further consideration. Moreover, use of an offshore subsidiary has some negative consequences, such as conversion of any long-term capital gains realized by the subsidiary to ordinary income when passed through to the RIC as dividends (or deemed dividends) and the trapping of capital losses at the subsidiary level.
  
  
• For fund complexes in the process of launching commodity funds, there may still be reasons to set up an offshore subsidiary, if only for a transitional period. For instance, the provision on commodities does not take effect until years beginning after the date of enactment of the Act. If the Act passes in December 2010, a RIC with an Oct. 31 fiscal year would not be able to rely on this provision until its next fiscal year commencing Nov. 1, 2011. More important, given the politics in Washington, D.C., passage of the Act in 2010 is not a sure thing. RICs that do not want to lose time in getting to market may still desire to proceed with an offshore subsidiary as a protective measure.
  
  
• The CFTC has requested public comment on the National Futures Association’s (NFA) rule-making petition to narrow the scope of the exclusion for registered investment companies from regulation as commodity pool operators. The proposal from the NFA would require a registered investment company seeking such exclusion to represent that it will use commodity futures and commodity options solely for bona fide hedging purposes, except for margins and premiums not exceeding 5 percent of the company’s liquidation value. It is unclear whether the Dodd-Frank Act will affect the scope of these representations.

Modifications in the House Bill. Additionally, Section 201 of the Act as passed by the House was slightly modified from the version proposed in December 2009, such that the present law definition of qualifying income for purposes of provisions relating to publicly traded partnerships will still apply. Therefore, in determining whether a publicly traded partnership is treated as a partnership for tax purposes by satisfying the gross income requirements of Code Section 7704(b)(2), qualifying income will not include income from commodities but will continue to include income from foreign currencies.⁵

In addition to numerous technical corrections to the Act as proposed, the Act as passed by the House includes the following substantive changes:

• In order to address the effect on earnings and profits in the year following a net capital loss caused by the Act’s change to the capital loss carryover rules, i.e., such losses are treated as arising on the first day of the next taxable year, the Act requires that the rules applicable to the taxable income treatment of a net capital loss apply for purposes of determining earnings and profits (both current earnings and profits and accumulated earnings and profits). Thus, a net capital loss for a taxable year is not taken into account in determining earnings and profits, but any capital loss treated as arising on the first day of the next taxable year is taken into account in determining earnings and profits for the next taxable year (subject to the application of the net capital loss rule for that year). If enacted, this provision is effective for taxable years beginning after the date of enactment.
  
  
• The proposed language of the Act required at least 95 percent of the value of the total assets of the RIC to be invested in other RICs in order to satisfy the definition of a qualified fund of funds and be eligible to pass through exempt interest dividends and foreign tax credits. The Act as passed by the House reduced the percentage from 95 percent to 50 percent.
  
• Under the modified spillover dividend rules, for purposes of the requirement that the distribution be paid not later than the date of the first dividend payment of the same type made after the declaration, a dividend attributable to short-term capital gain with respect to which a notice is required under the 1940 Act shall be treated as the same type of dividend as a capital gain dividend.
  
  
• Under present rules, if a shareholder receives an exempt-interest dividend with respect to a share of RIC stock held for six months or less, any loss on the sale or exchange of the stock, to the extent of the amount of the exempt-interest dividend, is disallowed. This loss disallowance rule is inapplicable with respect to a regular dividend paid by a RIC that declares exempt-interest dividends on a daily basis in an amount equal to at least 90 percent of its net tax-exempt interest and distributes the dividends on a monthly or more frequent basis, but gives the Secretary authority to issue regulations to prescribe a shorter holding period not shorter than the greater of 31 days or the period between the regular distributions. This provision applies to stock for which the taxpayer’s holding period begins after the date of enactment.
  
  
• The list of exempt entities that can hold shares of the RIC without it being subject to excise tax was further expanded to include another RIC to which Code Section 4982 does not apply.
  
  
• The required distribution for purposes of the excise tax is increased from 98 percent of the capital gain net income for the one-year period ending Oct. 31 of such calendar year to 98.2 percent. This provision applies to calendar years beginning after the date of enactment.

Moving the Act Forward. The Act is now in the Senate. It is unclear whether the Act will have opposition in the Senate (although certain commentators have suggested that it is unopposed). Additionally, the Act could be coupled with another more controversial bill. On Sept. 29, 2010, the Act was read for the first time in the Senate and placed on the Senate Legislative Calendar under Read the First Time. While nothing is certain, it is not likely that any further action will be taken on the Act in the Senate until after the November elections. Further, if passed by the Senate with any amendments, it will have to be reconciled in the House, further delaying its passage.

Impact on a Fund’s Operations. Assuming that the Act is enacted by the end of 2010, a RIC will have the opportunity to immediately take advantage of certain new and advantageous rules regardless of its year-end, e.g., the savings provisions for qualification failures, exchange treatment for distributions in redemption of the RIC stock and the modifications related to the excise tax. However, a RIC with a fiscal year-end in, for example, June or October will have to wait until its next tax year begins, July 1 or Nov. 1, respectively, to implement certain of the Act’s provisions, e.g., commodities qualifying as good income, repeal of the preferential dividend and the unlimited capital loss carry forward.

¹ For a review of the provisions in the Act as originally proposed in December 2009, see our Fund Alert, Regulated Investment Company Modernization Act of 2009, March 2010.

² Section 201 of the Act.

³ The term commodity is also defined in the Commodity Exchange Act and regulations thereunder to mean certain named commodities and all other goods and articles, except onions, and all services, rights and interests in which contracts for future delivery are presently or in the future dealt in.

⁴ In general, the RIC must satisfy the following asset diversification test at the close of each quarter of its tax year: (1) at least 50 percent of the value of the RIC’s assets must consist of cash and cash items, U.S. government securities, securities of other regulated investment companies, and securities of other issuers (as to which the RIC has not invested more than 5 percent of the value of its total assets in securities of an issuer and as to which the portfolio does not hold more than 10 percent of the outstanding voting securities of the issuer); and (2) no more than 25 percent of the value of the RIC’s total assets may be invested in the securities of any one issuer (other than U.S. government securities and securities of other regulated investment companies) or of two or more issuers that the RIC controls and that are engaged in the same or similar trades or businesses or, collectively, in the securities of QPTPs.

⁵ This change does not impact the classification of a partnership of which a principal activity is the buying and selling of commodities as described in Code §7704(c)(3).

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