Written by Christopher Denney, MPA, MST, CPA, CGMA, CVA, ABV
Congress made significant improvement in the tax treatment of RICs that should go a long way toward leveling the playing field when taxpayers compare the potential advantages and disadvantages of various entities as investment vehicles.
The Regulated Investment Company Modernization Act of 2010 (P.L. 111-325, 12/22/10; the "2010 Act") eases some of the tax compliance requirements for regulated investment companies (RICs). With the exception of certain changes made in 1978 and 1986, until the enactment of the 2010 Act much of the law governing RICs had been in place since the Technical Amendments Act of 1958.
Under the pre-2010 Act law, a RIC was faced with limitations on capital loss carryovers, stringent gross income and asset diversification tests, disqualification of preferential dividends on publicly offered RICs, and an excise tax filing requirement that applied even when all the shareholders were entities exempt from tax. These tax compliance requirements, along with the stringent requirements of the Investment Company Act of 1940 (the "1940 Act"), often made the RIC less likely to be the entity of choice in a given situation. As other aspects of the tax law evolved after 1958, other entity structures were considered, in some circumstances, a better choice. The 2010 Act generally makes RICs more appealing.
RICs IN GENERAL
A RIC generally is an electing domestic corporation or trust treated as a corporation that is registered under the 1940 Act. 1 Many RICs are mutual funds whose shares can only be bought from or redeemed by the company, and are not available for purchase or sale on the secondary market. These companies are considered "open-end" funds because the number of shares available continuously changes. Because they are not available on the open market, their shares are redeemed at net asset value. By contrast, shares in "closed-end" companies normally are available on the open market, either a national securities exchange or over-the-counter. These shares may not be redeemed on demand.
A benefit of electing RIC classification is that RICs are able to achieve the pooled management of a diverse portfolio of investments without two tiers of tax. This "single-tier" taxation differentiates a RIC from most corporations, which are taxed at the corporate level 2 and are separate economic units from their investors. The investors of these corporations are then taxed on dividends paid out of the corporation's E&P. 3 Single-tier tax entities (also known as pass-through entities) avoid most of this double taxation of earnings because all income is passed-through to the owners, who bear the burden of the income tax.
2010 ACT CHANGES
RICs are governed by Part I of Subchapter M of the Code ( Sections 851-855 ). Even though a RIC is a corporation, it accomplishes single-tier taxation by meeting an annual distribution requirement. A RIC must distribute at least 90% of its ordinary income to its shareholders in the tax year earned. 4 Since the RIC receives a deduction for dividends paid, any undistributed income will be taxed at the entity level at corporate rates. The RIC also will pay tax on any undistributed net capital gain. Therefore, most RICs distribute all income (ordinary and net capital gains) in order to avoid entity-level taxation. 5 Losses cannot be passed through to the shareholders. There are also no special allocations among owners.
The 2010 Act made changes in many areas, all of which are designed to simplify the tax structure:
- Reporting to shareholders.
- Capital loss carryovers.
- Gross income requirements.
- Asset diversification requirements.
- Excise tax.
- Deferral of certain losses incurred late in the calendar year ("late-year losses").
- Fund of funds pass-throughs.
- Dividends paid by RICs after the close of the tax year.
- Return of capital distributions by RICs.
- Stock redemptions by RICs.
- Publicly offered RIC preferential dividends.
- Exempt-interest dividends holding period requirement.
- Tax liability assessable penalties.
- Sale load basis deferral rule.
Written Designation vs. Reporting Requirements for Certain Distributions
Because a RIC relies on its shareholders to pay tax and receive credits on its income that is passed through to them, notification requirements are in place. Until the 2010 Act, all capital gain dividends, exempt-interest dividends, foreign tax credits, and certain dividends paid to nonresident alien individuals and foreign corporations, were to be provided to shareholders with certain written designation of amounts. These written designations have been modified to include reported amounts under the new law.6
Capital gain dividend distributions may be designated by the RIC as such in a written notice mailed to shareholders not later than 60 days after the close of the RIC's tax year. Nevertheless, if a RIC designates an aggregate amount of capital gain dividends for a tax year that exceeds the RIC's net capital gain, the portion of each distribution that is a capital gain dividend is only the proportion of the designated amount that the RIC's net capital gain bears to the total amount so designated by the RIC. 7
The excess dividend designated as a capital gain dividend is called an "excess reported amount." Until the 2010 Act, if the amount changed—whether by an amendment by the taxpayer, a closing agreement with the IRS, or a court decision—a written designation was to be made to shareholders within 120 days after the date of the determination. 8 Under the 2010 Act, the designation requirement for capital gain dividends must be reported to the IRS in addition to the shareholders, e.g., on a Form 1099. 9 The new law does not change the method of designation of undistributed capital gain taken into account by shareholders under Section 852(b)(3)(D) .
Example: A calendar-year RIC makes quarterly distributions of $40 for an annual total of $160. If at the end of the year only $120 of the RIC's income consists of net capital gain, only $30 of each quarterly distribution may be designated as such and treated as long-term capital gain by the shareholders.
Section 852 provides a special allocation rule for RICs that do not use the calendar year and have excess reported amounts. If the "post-December reported amount" equals or exceeds the excess reported amount for that tax year, the latter is allocated to the post-December reported amount and no excess reported amount is allocated to any dividend paid before January 1. The "post-December reported amount" is the aggregate amount reported with respect to items arising after December 31 of the RIC's tax year. 10
Example: A RIC's fiscal year ends 6/30/12. The RIC makes quarterly distributions of $40, for an annual total of $160. If at the end of the fiscal year only $120 of that is net capital gain, the excess reported amount is $40. Half of the excess reported amount, or $20, is allocated to the two post-December distributions, reducing the amount of each post-December distribution treated as a capital gain dividend from $40 to $30.
This allocation eliminates the need for RICs with noncalendar tax years to file amended Forms 1099, and concomitantly for its shareholders to file amended tax returns for any miscalculations or errors.
The treatment of excess reported amounts of exempt-interest dividends, passed-through foreign tax credits, and interest-related dividends and short-term gain dividends paid to certain nonresident alien individuals and foreign corporations by RICs is similar to the treatment described above applicable to capital gain dividends for the 60-day reporting requirement. 11
Capital Loss Carryovers
One anomaly with regard to a RIC's pass-through character before the 2010 Act was the limit imposed on net capital loss carryforwards. Generally, for noncorporate taxpayers, net losses from the sale or exchange of capital assets are allowed only up to $3,000 each year. 12 Individual taxpayers may carry forward remaining capital losses in excess of $3,000 until the losses are used up (or the taxpayer dies).
For corporations other than RICs, a net capital loss may be carried back to each of the three tax years preceding the loss year and carried forward to each of the five tax years following the loss year. The loss is treated as a short-term capital loss in each of those years. 13
Prior to the 2010 Act, a RIC could only carry a net capital loss forward to each of the eight tax years following the loss year, as a short-term capital loss. 14 Now, if a RIC has a net capital loss for a tax year, any excess of the net short-term capital loss over the net long-term capital gain is treated as a short-term capital loss arising on the first day of the next tax year. 15
There is no limit on the number of tax years that a RIC may carry forward a net capital loss incurred after 2010. This change more closely aligns the carryforward treatment of RICs with the treatment in Section 1212(b) of the individual shareholders who may be invested in them.
Example: A RIC has a net capital loss of $10 million for 2010 and $20 million for 2011; $5 million of the 2011 loss is short-term capital loss and $15 million is long-term. For 2012, a short-term asset is sold for a $6 million gain. Because all post-2010 Act losses are treated as arising on the first day of the next year, the $6 million gain will be netted first against the $5 million short-term capital loss and the remaining $1 million will be netted against the $15 million long-term capital loss carried forward. The remaining $14 million long-term capital loss from 2011, a post-enactment year, must be fully used before any of the $10 million net capital loss from 2010 can be used.
Without proper planning, pre-2010 Act losses may not be properly used and therefore may expire. The 2010 Act does not clearly stipulate that the effective date for application of this provision is available for excise tax as it is for regular tax purposes.
Gross Income Requirements
In addition to being an entity that is regulated under the 1940 Act, a RIC's gross income must be passive and meet an annual test. Under Section 851(b)(2) , at least 90% of the RIC's gross income should be derived from the following:
- Payments with respect to securities loans.
- Gains from the sale or other disposition of stock or securities or foreign currencies.
- Other income (including but not limited to gains from options, futures, or forward contracts) derived with respect to the RIC's business of investing in stock, securities, or foreign currencies.
- Net income derived from an interest in a qualified publicly traded partnership (PTP).
Before the 2010 Act, if an entity failed the annual gross income test, the failure meant that the corporation would not be treated as a RIC for that tax year and would lose its single-tier-taxation status for that year. Under Section 851(i)(1) as added by the 2010 Act, however, a failure that is due to reasonable cause and not willful neglect will not cause a RIC to lose its status if properly disclosed to the Service. The RIC must file a specified schedule with IRS, detailing its items of gross income. If the nonqualifying gross income of a RIC exceeds one-ninth of its qualifying gross income, a tax is imposed equal to the amount of such excess. 16
Example: The qualifying gross income of a RIC is $300 million. It also has nonqualifying gross income of $90 million. One-ninth of $300 million is $33 million. As a result, the tax would be $67 million, the amount of "excess" nonqualifying gross income ($90 million minus $33 million).
Asset Diversification Requirements
Section 851(b)(3)(A) requires that at the close of each quarter of the tax year, at least 50% of the value of the RIC's total assets should be invested in the following:
(2) Cash items (including receivables).
(3) Government securities.
(4) Securities of other RICs.
(5) Other securities that, with respect to any one issuer, do not represent more than 5% of the assets of the RIC or more than 10% of the voting securities of such issuer.
Also, not more than 25% of the value of the RIC's total assets may be invested in the securities (other than government securities or the securities of other RICs) of any one issuer, 17 or the securities (other than the securities of other RICs) of two or more issuers which the taxpayer controls (i.e., owns 20% or more of voting stock) and which are determined to be engaged in the same or similar trades or businesses or related trades or businesses, 18 or the securities of one or more qualified PTPs. 19
After the first quarter for which a corporation qualifies as a RIC, a market fluctuation in the value of its securities does not cause the RIC to be noncompliant with the asset test unless the discrepancy exists immediately after an acquisition of "any security or other property" and is wholly or partly a result of the acquisition. 20 In that event, the RIC may cure the noncompliance within a reasonable time after the close of such quarter. The RIC may dispose of any position or positions that may have enabled it to meet the tests at the end of the quarter. In particular, the RIC need not dispose of securities of the issuer that created the discrepancy. The RIC, however, is not permitted to rely on market fluctuations alone to cure the noncompliance during the cure period.
Should noncompliance due to market fluctuation exist in the first quarter of the RIC's existence, however, there is no cure available to the RIC except for the acquisition of a security within a reasonable period after the close of the quarter.
The 2010 Act provides for both a de minimis cure as well as a non-de minimis cure for an asset test failure that is identified and the assets are disposed of within six months (a reasonable time) of the last day of the quarter. 21 Under the old law, a reasonable period for curing an asset test failure was 30 days. 22 The new law provides for a de minimis cure if the failure is not due to the ownership of assets the total value of which does not exceed the lesser of (1) 1% of the total value of the RIC's assets at the end of the quarter for which the assets are valued and (2) $10 million. 23
Non-de minimis asset test failures also have a cure mechanism, provided the failure to meet the asset tests is due to reasonable cause and not willful neglect. Following the identification of the failure to satisfy the asset tests, the RIC must set forth (in a schedule filed as IRS may direct) a description of each asset that causes the corporation to fail to satisfy the requirements at the close of the quarter. Within six months of the last day of the quarter in which the RIC identifies that it failed the asset test, the RIC either (1) disposes of the asset that caused the asset test failure, or (2) otherwise meets the requirements of the asset tests as added by the 2010 Act.
The non-de minimis failure will result in a tax in an amount equal to the greater of $50,000 or the amount determined by multiplying the highest rate of tax imposed on corporations, currently 35%, by the net income generated during the period of asset test failure by the assets that caused the RIC to fail the asset tests. 24
Section 4982 imposes an excise tax on RICs for undistributed income. The tax is equal to 4% of the excess of the "required distribution" for the calendar year over the distributed amount for that year. A required distribution is (1) 98% of a RIC's ordinary income for the year 25 plus (2) 98.2% of the RIC's capital gain net income for the one-year period ending on October 31 of the calendar year. 26 A required distribution for any year is the sum of the taxable income of the RIC for the year and all undistributed amounts from previous years. 27
A RIC receives a deduction for dividends paid to the extent of its taxable income and net capital gain income. 28 The distributed amount is the sum of the deduction for dividends paid during the year and amounts imposed for corporate income tax on the RIC for tax years ending during the calendar year. 29 After the 2010 Act, estimated taxes paid during the calendar year in which the tax year begins may be applied towards the distributed amount; if elected under Section 4982(c)(4) , this distributed amount is reduced by the estimated taxes paid in the prior year.
Before the 2010 Act, with the exception of seed money shares not exceeding $250,000, 30 the only RICs that were exempt from excise tax were those whose shareholders were only tax-exempt qualified pension plans and segregated asset accounts held in connection with variable contracts. 31 The new law expands this category to include qualified annuity plans described in Section 403 , IRAs (including Roth IRAs), certain government plans described in Section 414(d) or 457 , and pension plans described in Section 501(c)(18) . 32 In addition, a RIC exempt from excise tax under these exceptions may invest in another RIC exempt from excise tax and each still will maintain excise-tax-exempt status. 33
Deferral of Late-Year Losses
Special provisions apply to capital losses and ordinary losses incurred late in the calendar year, i.e., after October.
Post-October capital loss. A RIC must distribute net capital gains (as determined with reference to capital gains dividends) to avoid entity-level income tax under Section 852(b)(3)(A) and excise tax under Section 4982(a) . The determination of the required capital gains dividend is made without consideration, for excise tax distribution purposes, of any net capital loss or net long-term capital loss from transactions incurred after October 31. 34 These amounts are not included in the determination of the distribution for a tax year as they are recognized as if the transaction amounts were incurred on the first day of the next tax year. 35
This deferral or "push" of net capital losses and net long-term capital losses was automatic for purposes of determining a capital gain dividend. The treatment of these losses that are pushed by calendar-year RICs under Section 852(b)(8)(B)(i) is elective for the determination of taxable income.
Section 852(b)(8)(C) , as amended by the 2010 Act, defines post-October capital loss as the greatest of:
(1) The net capital loss attributable to the portion of the tax year after October 31;
(2) The net long-term capital loss attributable to that portion of the tax year; or
(3) The net short-term capital loss attributable to that portion of the tax year.
Before the 2010 Act, there were no specific rules that applied to short-term capital losses after October 31 for purposes of defining a capital gain dividend. For purposes of short-term capital gain dividends received by foreign persons, the net short-term capital gain of the RIC is computed by treating any short-term capital gain dividend includable in gross income with respect to stock of another RIC as a short-term capital gain. 36
A RIC with a tax year ending in November or December may elect to determine its capital gains excise tax distribution requirement on a tax-year basis instead of an October 31 12-month year. 37 A November year-end RIC that determines its net income during the full year for excise tax purposes will not be allowed to defer its late-year capital losses.
Any late-year ordinary loss. Deferral is required for post-October foreign currency gains and losses attributable to Section 988 transactions, 38 and any ordinary income from marketable PFIC stock for which mark-to-market treatment is elected under Section 1296 . 39 Similar to the post-October capital gain, these amounts are not included in the determination of the excise tax distribution for a tax year as they are recognized as if the transaction amounts were incurred on the first day of the next tax year. 40 After the 2010 Act, the income tax distribution deferral is elective for all or part of these post-October items, under Section 852(b)(8) .
The 2010 Act defines a "late-year ordinary loss" 41 as the excess (if any) of:
(1) The sum of (a) the specified losses attributable to the portion of the tax year after October 31 and (b) other ordinary losses not described in (a) that are attributable to the portion of the tax year after December 31, over
(2) The sum of (a) the specified gains attributable to the portion of the tax year after October 31 and (b) other ordinary income not described in (a) that is attributable to the portion of the tax year after December 31.
Because the required deferral of ordinary losses has expanded, a November or December year-end RIC cannot get the full benefit of deferral. Under the 2010 Act, they must compute qualified late-year losses under Section 852 in the tax year rather than pushing those losses.
The deferred or "pushed" income and net capital loss items are labeled under the 2010 Act as "specified gains and losses." Specified gains and losses are defined in Section 4982(e)(5)(B) as 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 42 and amounts under Sections 1296(a)(1) and (2) .
The 2010 Act does not make a separate distinction for disposition of an electing PFIC, but new Section 4982(e)(6)(B) defines "specified mark to market provision" to include property held by a RIC which under any provision of the Code and Regulations is treated as disposed of on the last day of the tax year. With proper planning, a RIC may take advantage of the elective deferral under the 2010 Act, as illustrated below.
Example: A RIC with a tax year ending 6/30/12 recognizes a long-term capital gain of $1 million on 9/15/11. To avoid the excise tax, the RIC distributes $982,000 on 12/15/11, which it designates as a capital gain dividend. On 1/15/12, the RIC recognizes a $600,000 long-term capital loss. The RIC has no other income or loss during 2011, 2012, and 2013 and has no accumulated E&P.
Absent the post-October loss election, the RIC would have a net capital gain (and current E&P) of only $400,000 for the tax year ending 6/30/12. Only $400,000 of the 12/15/11 distribution would be a capital gain dividend; the remaining $582,000 of the $982,000 distributed on 12/15 would be a return of capital. Because the "distributed amount" for excise tax purposes takes into account only those distributions for which a dividends-paid deduction is allowed, the RIC's distributed amount for calendar year 2011 would be $400,000, which is less than the distributed amount required to avoid the excise tax. In addition, the shareholders may have improperly reported the distribution as a capital gain dividend on their 2011 income tax returns.
By "pushing" the post-October long-term capital loss to 7/1/12, the entire $982,000 paid on 12/15/11 is a capital gain dividend. The distribution is fully deductible in computing the excise tax. No excise tax is imposed for 2011 because the RIC has no undistributed income.
Example: A RIC with a tax year ending 6/30/12 recognizes a short-term capital gain of $1 million on 9/15/11. Short-term capital losses are not deferred. Thus, to avoid excise tax a distribution is required for the short-term capital gain in the amount of $982,000 on 12/15/11. On 5/15/12, the RIC recognizes a $1 million long-term capital gain and a $1 million short-term capital loss. If the RIC has no other income or loss for 2011 and 2012 (and has no accumulated E&P), shareholders would receive a Form 1099 for 2011 that reports an "other than capital gain" dividend in the amount of $1 million.
Because the RIC has only $1 million of current E&P for its tax year, the RIC may not pay an additional distribution designated as a capital gain dividend for its tax year in order to be allowed a dividends-paid deduction in computing the RIC's tax on net capital gain. Instead, the RIC could designate the 12/15 distribution as a capital gain dividend, but at the cost of requiring shareholders to amend their income tax returns.
For a fiscal year-end RIC, as mentioned, the new rule concerning the "post-December reported amount" would reduce the impact of changes for excess amounts after December.
Earnings and Profits
Corporations make dividend distributions based on current and accumulated E&P. 43 E&P is taxable income with certain modifications. The E&P calculation is based on the concept that a corporation's shareholders should be taxed on its current distributions that are not considered a return of capital. E&P also affects the Section 4982 excise tax calculation.
Before the 2010 Act, the E&P calculation did not include any deductions related to tax-exempt interest, such as interest and amortizable bond premium pertaining to tax-exempt interest. 44 Even though these deductions are still not allowed in determining taxable income, they will be allowed in determining current E&P (but not to the extent of accumulated E&P). 45
Example: A RIC that does not have accumulated E&P has net tax-exempt interest income of $1 million ($2 million of gross tax-exempt interest income and $1 million of deductions related to the tax-exempt interest). Under the 2010 Act, a $2 million distribution treats the $1 million of the distribution (as it relates to the exempt-interest dividends deduction) as a return of capital (or gain to the shareholder). Under prior law, the $1 million would be taxed as ordinary dividends.
Also, under former Section 852(c)(2), a net capital loss that reduced income either in the year that the loss arose or any tax year to which the loss was carried would not reduce current E&P. The 2010 Act, in Section 852(c)(1)(A) , permits the same treatment of net capital loss for both taxable income and E&P. As a result, a RIC that does not include a net capital loss for a tax year does not take that loss into account for E&P; the loss is treated as arising on the first day of the following tax year and would reduce that year's current E&P (subject to all capital loss rules). 46
Fund of Funds Pass-Throughs
Under prior law, a "fund of funds" structure—that is, a RIC that owned other RICs—was limited in the benefit of exempt-interest dividends under Section 852(b)(5) and foreign tax credits under Section 853(a) that it could pass through to its shareholders. This was because the upper-tier RIC did not directly meet the asset ownership requirements; it only owned the shares of those RICs that did meet the requirements. The upper-tier RIC would be entitled only to a tax deduction for any of the foreign tax credits received, and would modify the character of the exempt-interest dividends.
Under Section 852(g) as added by the 2010 Act, an upper-tier RIC that is a qualified fund of funds may pass through these benefits without having to meet the 50% asset requirement. Specifically, the RIC may pass through exempt-interest dividends even though, at the close of each quarter of the tax year, it does not have at least 50% of the value of its assets in bonds or other debt obligations issued by state or local governments that earn tax-exempt interest under Section 103(a) . Similarly, the RIC may pass through foreign tax credits, even though, at the close of the tax year, not more than 50% of the value of its total assets consist of stock and securities in foreign corporations. This increases the tax efficiency of a fund-of-funds structure, as the true character and benefit that a shareholder would have in those attributes are passed through to the investors.
Post-Year-End Dividends Paid
Under pre-2010 Act law, dividends paid after the close of a tax year could be considered paid during the tax year for purposes of the RIC distribution requirements and the determination of the RIC's taxable income ("spillover dividends"). These dividends were to be declared prior to the time that the RIC's return for that year was filed (including extensions), and the distribution had to be made in the 12-month period following the close of the tax year and not later than the first dividend payment after the declaration.47
The 2010 Act modifies the timeline for declaration to either the later of the 15th day of the ninth month following the close of the tax year or the extended due date for filing the return. 48 Also, the previous requirement that the distribution be made not later than the date of the first dividend payment after the declaration is changed to not later than the date of the first dividend payment of the "same type" of dividend made after the declaration. 49 This clarifies that capital gain dividends would not be required by the first dividend date if those dividends only consist of other ordinary income dividends.
Return of Capital Distributions
In general, a dividend distribution is made out of a corporation's accumulated E&P or current E&P. 50The current E&P is prorated among current distributions. 51 Distributions of property that are not considered a dividend distribution reduce the adjusted basis of a shareholder's stock and are treated as gain to the extent that they are in excess of the basis that the shareholder has in the stock. 52
Because it is difficult for a noncalendar-year RIC to meet calendar-year reporting requirements and properly allocate the current E&P calculation throughout the year, the 2010 Act allows for a noncalendar-year RIC to allocate these to the first distributions made on or before 12/31 of the tax year. 53 Example: A March 31 year-end RIC that has $3 million of current E&P and no accumulated E&P makes quarterly distributions totaling $4 million. Under pre-2010 Act law, only $750,000 of each distribution would be considered E&P and a dividend; the remaining $250,000 of each distribution would be applied against each shareholder's basis as a return of capital, or considered capital gain. Under the 2010 Act changes, the June, September, and December distributions would all be considered dividends, with the entire March 31 distribution to be considered a return-of-capital distribution, as a reduction of each shareholder's basis or gain to the shareholder. This change in treatment is expected to reduce the amount of amended tax returns.
This calculation is applied separately to each class of stock. 54
RIC Stock Redemptions
In general, under Section 302(a) redemptions of corporate stock are treated as an exchange if the transaction fits into one of four categories:
(1) A redemption that is not essentially equivalent to a dividend, i.e., there is a meaningful reduction in the shareholder's proportionate ownership in the corporation.
(2) A substantially disproportionate redemption as defined in Section 302(b)(2)(C) .
(3) A redemption that terminates the shareholder's interest in the corporation ( Section 302(b)(3) ).
(4) A partial liquidation, in the case of a redemption of stock from a noncorporate shareholder, under Section 302(b)(4) .
If the transaction does not meet the criteria for one of the four categories that qualify as a redemption, it is treated as a distribution of property under Section 301 .
Before the 2010 Act, there was little guidance regarding the application of the not essentially equivalent to a dividend standard to an open-end RIC, whose shareholders "sell" their shares by having them redeemed by the issuing RIC and multiple redemptions by different shareholders may occur daily. A deduction for a loss from the sale or exchange of property between members of a controlled group must be deferred until there is a transfer of property outside of the group ( Section 267 ). For a fund of funds, before the 2010 Act a lower-tier fund would have been required to redeem shares when upper-tier fund shareholders demanded redemption of their shares. Because upper-tier and lower-tier funds may be members of the same controlled group of corporations, any loss by the upper-tier fund on the disposition of the lower-tier fund shares would have been deferred. 55
Under the 2010 Act, except as provided in Regulations, the redemption of stock of a publicly offered RIC is treated as an exchange if the redemption is at the demand of the shareholder and the company issues only stock that is redeemable at the demand of the shareholder and is redeemed due to the demand of another RIC.56As defined in Section 67(c)(2)(B) , RICs that are publicly offered are:
- Continuously offered pursuant to a public offering,
- Regularly traded on an established securities market, or
- Held by no fewer than 500 persons at all times during the tax year.
Publicly offered RIC preferential dividends. As previously noted, RICs are allowed a deduction, under Section 561 , for dividends paid to their shareholders. To qualify for the deduction, a dividend must not be a "preferential dividend" (excluding dividends from publicly offered RICs under Section 67(c)(2)(B) ).
A dividend will not be deemed preferential if it is distributed pro rata to shareholders, with no preference to any particular shares in the same class, and to the extent that no preference is issued to one class over another class except to the extent that the class is entitled to a preference. 57 Securities laws, administered by the SEC, limit the ability of RICs to issue shares with preferences.
As discussed above in connection with the redemption of RIC stock, and except as provided in Regulations, the 2010 Act treats the redemption of stock of a publicly offered RIC as an exchange if the redemption is at the demand of the shareholder and the company issues only stock that is redeemable at the demand of the shareholder.
The 2010 Act repeals the preferential dividend rule for publicly offered RICs. If a RIC is not publicly offered within the meaning of Section 67(c)(2)(B) , a distribution to any shareholder whose initial investment was $10 million or more is not treated as preferential if the distribution is increased to reflect reduced administrative cost of the RIC with respect to that shareholder. 58
Exempt-Interest Dividends—Holding Period Requirement
Prior to the 2010 Act, if a shareholder received 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, was disallowed. 59 Treasury was authorized to prescribe a shorter holding period applicable to a RIC that regularly distributed at least 90% of its tax-exempt interest. 60
Under the 2010 Act, the disallowance rule is now inapplicable to RICs declaring on a daily basis a dividend equal to at least 90% of its tax-exempt interest, and which distribute those dividends on a monthly or more frequent basis. 61
Tax Liability Assessable Penalties
A deficiency dividend, as defined in Section 860 , is a distribution that relates to a prior year due to a determination of a tax deficiency. The determination could be a Section 7121 closing agreement, a final decision of the Tax Court or other court, a signed tax liability agreement, or a statement by the taxpayer attached to its amendment or supplement to a return for a given year.
Prior to the 2010 Act, if it was determined that a RIC had a tax deficiency with respect to a prior year, a penalty also could be assessed under former Section 6697. This penalty would subject the RIC to the lesser of the interest charge on the deficiency or one-half of the deduction allowed under Section 860(a) for the payment of the deficiency dividend.
The 2010 Act eliminates the penalty associated with paying a deficiency dividend, and repeals Sections 860(j) and 6697.
A load charge is a sales charge or similar cost that is incurred in acquiring stock in a RIC. 62 Before the 2010 Act, Section 852(f)(1) provided that a load charge was not taken into account in determining gain or loss (i.e., as part of the taxpayer's basis) in certain circumstances:
(1) By reason of incurring the load charge or acquiring the stock, the taxpayer acquired a reinvestment right,
(2) The stock was disposed of within 90 days after the acquisition, and
(3) The taxpayer subsequently acquires stock in the original RIC or another RIC, and the new load charge is reduced by reason of the reinvestment right.
Under the 2010 Act, Section 852(f)(1)(C) was amended to limit the period during which the taxpayer reacquires the RIC stock. The deferral of the load charge will apply if the taxpayer reacquires the RIC stock during the period beginning on the date of the original disposition (item 2, above) and ending on January 31 of the calendar year following the calendar year that includes such disposition.
MAKING THE RIC THE ‘MODERN’ CHOICE
Some of the changes made by the 2010 Act support the argument for using a RIC as an investment pass-through entity.
While partnerships always have had the benefit of passing income and losses through to their partners, an investment in a partnership carries with it potential concerns about basis as well as unwanted minimum gain chargebacks under Section 704(b) . Unlike partnerships, RICs cannot pass losses on to their respective owners. This meant that before the new law, RIC owners might never receive the benefit of capital losses in a string of loss years because the losses would expire unused. The new unlimited carryforward rule for a RIC's capital losses is a substantial improvement. It also compares favorably with the treatment of REITs, which can carry forward losses for only five years.
The 2010 Act also eases the provisions affecting a RIC's late-year deferral of taxable income and excise tax. While REMICs and REITs also have excise tax exposure, they did not have many of the timing rules that affected RICs, which are now simplified. Repeal of the penalty associated with paying a deficiency dividend also lessens some of the concerns regarding possible prior-year income tax exposure.
The simplified rules for RICs under the 2010 Act makes them much more desirable as an investment entity. Investment vehicles often have a changing investor pool, and the RIC structure does not entail the complicated tax basis accounting of partnerships that arises in connection with allocations to partners. Also, a corporate investor that receives dividends from a RIC generally does not have to exclude dividends it receives from the dividends-received deduction calculation (as it does for a dividend from a REIT).
1 Section 851(a)(1)(A) . 2 The corporate income tax imposed by Section 11 . 3 Sections 301 and 302 . 4 Section 852(a) . 5 Sections 852(b)(1) and (3) . 6 Sections 852(b)(3)(C)(i) , 852(b)(5)(A)(i) , 853(c) , and 854(b)(1)(A) . 7 See Sections 852(b)(3)(B) and (C) . 8 Former Section 852(b)(3)(C). 9 Section 852(b)(3)(C)(i) . 10 Section 852(b)(3)(C)(iii)(II) . 11 Sections 852(b)(5)(A)(i) , 853(c)(2) , and 854(b)(1)(A)(ii) . 12 Section 1211 . 13 Section 1212(a)(1)(A) . 14 Former Section 1212(a)(1)(C)(i). 15 Section 1212(a)(3)(A) . 16 Section 851(i)(2) . 17 Section 851(b)(3)(B)(i) . 18 Sections 851(b)(3)(B)(ii) and 851(c)(3) . 19 Section 851(b)(3)(B)(iii) . 20 Section 851(d)(1) . 21 Sections 851(d)(2)(A)(iii)(I) and 851(d)(2)(B)(ii)(I) . 22 Former Section 851(d). 23 Sections 851(d)(2)(B)(i)(I) and (II) . 24 Section 851(d)(2)(C) . 25 Section 4982(b)(1)(A) . 26 Section 4982(b)(1)(B) . The 2010 Act increased the required distribution percentage of capital gain net income from 98% to 98.2%. 27 Section 4982(b)(2) . 28 Sections 4982(c)(1)(A) and 561 . 29 Section 4982(c)(1)(B) . 30 Section 4982(f) . 31 Sections 4982(f)(1) and (2) . 32 Section 4982(f)(3) . 33 Section 4982(f)(4) . 34 Sections 4982(b)(1)(B) and (e)(2)(C)(i) . 35 Section 4982(e)(2) under the excise tax rules and Section 852(b)(3)(C) for income tax. 36 Section 871(k)(2)(D) . 37 Section 4982(e)(4) for excise tax and Reg. 1.852-11(b)(2) for income tax. 38 These are now part of the "specified gains and losses" for excise tax under Sections 4982(e)(5)(B)(i) and (ii) , and are cross-referenced under Sections 852(b)(8)(D)(i)(I) and (D)(ii)(I) . 39 Section 4982(e)(6)(A) . 40 Sections 4982(e)(2)(C)(i) and (ii) . 41 Section 852(b)(8)(D) . 42 Section 988 . 43 Sections 312 , 316 , 561 , 562(a) , and 852(a)(1) . 44 Former Section 852(c)(1). 45 Section 852(c)(1)(B)(i) . 46 Section 852(c)(1)(A)(ii) . 47 Former Section 855(a). 48 Sections 855(a)(1)(A) and (B) . 49 Section 855(a)(2) . 50 See note 43, supra. 51 Reg. 1.316-2(b) . 52 Sections 301(c)(2) and (3) . 53 Section 316(b)(4) . 54 Rev. Rul. 69-440, 1969-2 CB 46 . 55 Section 851(g) . 56 Section 267(f)(3)(D) . The loss deferral rule also does not apply if the transferor or the transferee is a domestic international sales corporation ( Section 267(f)(3)(A) ), to certain sales of inventory ( Section 267(f)(3)(B) ), and to certain foreign currency losses ( Section 267(f)(3)(C) ). 57 Section 562(c) . 58 Id. 59 Section 852(b)(4)(B) . 60 Former Section 852(b)(4)(B). 61 Section 852(b)(4)(E)(i) . Treasury's authority to issue Regulations prescribing a holding period shorter than six months for other RICs is now found in Section 852(b)(4)(E)(ii) . 62 Section 852(f)(2)(A) . This is not the same as a charge that is part of a "reinvestment dividend" (as defined in Section 852(f)(2)(B) ).