What s News in Tax Analysis That Matters from Washington National Tax

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1 What s News in Tax Analysis That Matters from Washington National Tax Wednesday, October 6, 2010 The Regulated Investment Company Modernization Act of 2010: Proposed Legislation Would Update the Tax Rules for RICs The U.S. House of Representatives approved the Regulated Investment Company Modernization Act of 2010 before Congress wrapped up its session early. The House passage is a step towards modernization of the regulated investment company ( RIC ) statutory provisions and technical corrections. This article provides a brief overview of RICs and a detailed analysis of the proposed legislation in the following categories amendments to the gross income and asset diversification rules, amendments to the distribution rules, and miscellaneous amendments. by Dale Collinson, Liz Dyor, and Deanna Flores, Washington National Tax Dale S. Collinson is a director in WNT s Financial Institutions and Products Group and a former IRS Special Counsel, former Treasury Tax Legislative Counsel, and former U.S. Supreme Court law clerk. Liz R. Dyor is a director in WNT s Financial Institutions and Products Group (Seattle), and Deanna J. Flores is a principal in WNT s Financial Institutions and Products Group (San Diego). On September 28, 2010, the U.S. House of Representatives approved H.R. 4337, the Regulated Investment Company Modernization Act of 2010 (the Bill ). An earlier version of the Bill was introduced on December 16, 2009, by former House Ways and Means Committee Chairman Charles Rangel (D-NY). The Bill s provisions can be grouped into three broad categories: (1) amendments to the gross income and asset diversification rules, (2) amendments to the distribution rules, and (3) miscellaneous amendments. Some of the more significant changes are: Unlimited capital loss carryovers (see II.C.1 infra) Inclusion of commodity income in qualified income (see II.A.1 infra) Relief for qualifying income and diversification test failures (see II.A.2 infra) KPMG and the KPMG logo are registered trademarks of KPMG International Cooperative, a Swiss entity.

2 Proposed Legislation Would Update the Tax Rules for RICs page 2 Redemptions of open-end funds treated as exchanges rather than dividends (see II.B.6 infra) Repeal of preferential dividend rule (see II.B.7 infra) Eliminate penalty on deficiency dividends (see II.B.10 infra) Eliminate duplicative designation requirement for dividends and distributions (see II.B.12 infra) Eliminate loss disallowance for shareholders in tax-exempt bond funds who sell shares held for six months or less in the case of funds declaring exempt-interest dividends on a daily basis (see II.B.11 infra) Increase in the excise tax capital gain distribution requirement (see II.B.8 infra) This article starts with a brief overview of RICs and then provides a summary of the Bill s provisions. I. Overview of RICs In general, RICs are domestic corporations that (1) are regulated under the Investment Company Act of 1940 (the 1940 Act ), (2) elect to be treated as a RIC for U.S. federal income tax purposes, and (3) meet certain gross income and asset diversification requirements. 1 To satisfy the gross income requirements, at least 90 percent of a RIC s income must be good income derived from specified passive investment sources. 2 To satisfy the asset diversification requirements, at least 50 percent of the value of a RIC s total assets must be invested in cash, cash items (including receivables), government securities, securities of other RICs, or investments in other securities that, with respect to any one issuer, do not represent more than five percent of the RIC s assets or more than 10 percent of Unless otherwise indicated, references to section or sections in this article are to the Internal Revenue Code of 1986 (the Code ), as most recently amended, or to the U.S. Treasury Department regulations, as most recently adopted or amended. the issuer s voting securities. 3 Additionally, not more than 25 percent 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 (1) any one issuer, (2) two or more issuers controlled by the RIC and engaged in the same or similar trades or Section 851. Section 851(b)(2). Good income includes interest, dividends, gains from sales of stocks, securities, and foreign currencies, and gains on certain derivatives that relate to stock, securities, and foreign currencies. Good income also includes net income derived from a qualifying publicly traded partnership as defined in section 851(h). Sections 851(b)(2)(A) and (B). Section 851(b)(3)(A).

3 Proposed Legislation Would Update the Tax Rules for RICs page 3 businesses or related trades or businesses, or (3) one or more qualified publicly traded partnerships. 4 Some of the Bill s provisions would modify the rules relating to these gross income and diversification requirements. RICs are generally taxable as regular corporations but are subject to the special rules set forth in subchapter M of the Code. Under subchapter M, RICs are generally relieved of entity-level income taxation to the extent they distribute substantially all of their income and gains to their shareholders within certain prescribed time periods. Eliminating an entity-level income tax is accomplished by providing RICs with a dividends paid deduction under section 561 for certain distributions of ordinary income, capital gain net income, and tax-exempt interest paid to their shareholders. 5 In addition to potentially being subject to income tax, a RIC will be subject to a four percent excise tax under section 4982 if it does not distribute at least 98 percent of its ordinary income for the calendar year, 98 percent of its capital gain net income for the one-year period generally ending on October 31, and any previously undistributed ordinary income and capital gain net income from prior calendar years. Thus, in order to avoid both an income tax and an excise tax, it is imperative that a RIC make adequate distributions of its income and gains to its shareholders. 6 Many of the Bill s provisions relate to the tax treatment of RIC distributions Section 851(b)(3)(B). Section 852(b). If a RIC were to fail to meet the requirements of subchapter M, the RIC s net income would be subject to corporate tax at the entity level when recognized and again when distributed to shareholders (like other domestic corporations). For example, significant complexity can arise for RICs that have a tax year other than the calendar year. In that case, a RIC s taxable income for the year may not be known until after distributions are required to be made to its shareholders (to avoid an excise tax, RICs generally must make distributions prior to the end of the calendar year). Furthermore, RICs are required to notify their shareholders of the character of any distributions made to its shareholders. A distribution may be an ordinary dividend to the extent the RIC has current or accumulated earnings and profits. Furthermore, in certain cases a RIC can pass through the character of its capital gain and tax-exempt income by paying capital gain dividends and exempt-interest dividends. RICs may also pass through certain tax credits, including foreign tax credits and credits on tax-credit bonds. For non-calendar year RICs, post-december 31 events may affect a RIC s taxable income, earnings and profits, etc. and the character of a distribution as previously reported to a RIC s shareholders may be incorrect. In that case, the RIC could be required to provide its shareholders with amended Form 1099s and the shareholders could be required to file amended tax returns. Some of the Bill s provisions are designed to address these issues.

4 Proposed Legislation Would Update the Tax Rules for RICs page 4 II. Bill Provisions The Bill addresses a number of issues and provides the first general overhaul of the RIC rules in over 20 years. As mentioned above, the Bill would amend the gross income and diversification rules of section 851, and also would provide additional rules designed to eliminate issues for non-calendar year RICs. The Bill also would remove obsolete provisions and address other technical rules that, when applied to RICs, can produce potentially adverse effects. An overview of the Bill s provisions is provided below. A. Modifications to Gross Income & Asset Diversification Requirements 1. Income from Commodities Would Qualify as Good Income (Section 201 of the Bill) Under current law, gain from stocks, securities, foreign currencies, and certain derivative contracts on stocks, securities, and foreign currencies is good income for purposes of the gross income test. Gain from the sale or disposition of commodities, or contracts (including options, futures contracts, and forward contracts) on commodities, is not, however, good income under current law. 8 Thus, RICs may be limited in their ability to provide investors with commoditybased returns. 9 The Bill would amend section 851(b)(2) to include gain from commodities (and contracts on commodities) as good income. 10 However, the Bill s amendments to include gain from commodities (and contracts on commodities) in the definition of See Rev. Rul , C.B. 261; Rev. Rul , C.B (holding that a RIC s income from a derivative contract with respect to a commodity index is not qualifying income for purposes of section 851(b)(2)). Income from certain commoditylinked notes may be qualifying income, however. See, e.g., Private Letter Rulings , , , , , and However, a number of RICs have been organized to provide commodity-based returns through a combination of commodity-linked notes, see supra note 8, and investments in controlled foreign corporations that invest in commodities. See, e.g., Private Letter Rulings , , Under current section 851(b)(3), the IRS has regulatory authority to exclude from good income foreign currency gains which are not directly related to a RIC s principal business of investing in stock or securities (or derivatives on stock or securities). The Bill would remove this regulatory authority. Further, the amendment to include gain from commodities in good income would be done by striking references to foreign currency in section 851(b)(2)(A). The elimination of references to, and regulatory authority regarding, foreign currencies could be read to suggest that foreign currency may also be considered a commodity.

5 Proposed Legislation Would Update the Tax Rules for RICs page 5 good income for RIC purposes would not apply for purposes of the publicly traded partnership rules. 11 These provisions would apply to tax years beginning after the date of enactment. 2. Relief for Failures to Comply with Gross Asset and Qualifying Income Tests (Section 202 of the Bill) The Bill would provide RICs with relief from certain failures to comply with the gross income and asset diversification requirements of section 851(b). Under the Bill, a RIC that fails the asset diversification requirement by a de minimis amount would be treated as satisfying the requirement if: The RIC disposes of sufficient assets to cure the failure within six months of the last day of the quarter for which the failure occurred, or The RIC otherwise satisfies the diversification requirement within the same six-month period. De minimis for this purpose would mean the lesser of one percent of the total value of the RIC s assets at the end of the quarter for which the assets are valued, or $10 million. If a RIC s diversification failure is not de minimis, a RIC would avoid losing its RIC status if: The failure to comply with the diversification requirement was due to reasonable cause (and not willful neglect), The RIC notifies the IRS of the failure by providing the IRS with a description of each asset that caused the RIC to fail to satisfy the asset diversification test, 12 and Publicly traded partnerships are generally treated as corporations for tax purposes unless at least 90 percent of the partnership s gross income consists of qualifying income. Qualifying income for this purpose includes income that is considered good income for RIC purposes (as defined in section 851(b)(2)(A)). Under the Bill, the present-law definition of qualifying income (which includes gains from dispositions of foreign currency but not gains from commodity transactions) would continue to apply for purposes of the section 7704(c) passive-income exception applicable to publicly traded partnerships. However, income qualifying for the passive income exception would continue to include commodity income described in section 7704(d)(1)(G), which applies only to certain commodity partnerships. Rules for filing the disclosure with the IRS would be provided by the Secretary.

6 Proposed Legislation Would Update the Tax Rules for RICs page 6 The RIC disposes of the nonqualifying assets within six months of the end of the quarter in which the failure to satisfy the asset test was identified (or the RIC otherwise meets the requirements of the asset diversification test within the same six-month period). For failures that are not de minimis, the RIC would be required to pay an excise tax equal to the greater of $50,000, or, as provided by the Secretary, the product of the net income generated from the bad assets during the period of failure and the highest corporate tax rate in effect at the time. These savings provisions are modeled after rules that apply under current law to real estate investment trusts (REITs). 13 The Bill would also amend section 851 to allow RICs that fail to comply with the gross income requirement to be treated as satisfying the gross income requirement if (1) the failure is due to reasonable cause and not willful neglect, (2) the RIC discloses to the IRS in a manner specified by the Secretary a description of the nonqualifying income, and (3) the RIC pays a tax to the IRS equal to the excess of the nonqualifying income over one-ninth of the RIC s qualifying income. 14 Thus, rather than be subject to tax at a 35-percent rate on its overall net income, the RIC would pay a tax on the amount of gross income earned from nonqualifying sources that exceeds one-ninth of the RIC s gross income from qualifying sources. 15 These provisions would apply to tax years with respect to which the due date (including extensions) of the tax return for such tax year is after the date of enactment Section 856(c). For purposes of calculating investment company taxable income under section 852(b)(2), RICs would be allowed to deduct taxes paid due to failures to comply with the qualifying income and diversification requirements under the revised rules. 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 under the Bill. The tax is the amount by which the $15X gross income from sources that are not qualifying income exceeds the $10X permitted under present law. The statutory formula in effect gives a RIC the same bad income basket, as a percentage of qualifying income, that is provided by the general rule requiring that 90 percent of a RIC s gross income be good income.

7 Proposed Legislation Would Update the Tax Rules for RICs page 7 B. Modifications to Rules for RIC Distributions 1. Post-December 31 Allocation Rules (Section 301 of the Bill) RICs can specify the character of distributions made to their shareholders. For example, a RIC can distribute a capital gain dividend to the extent of the RIC s net capital gain for its tax year. Similar rules apply to exempt-interest dividends, shortterm capital gain dividends, and interest-related dividends. Information regarding the character of RIC dividends and distributions is provided to RIC shareholders on Form 1099 information returns. If a RIC does not use the calendar year as its tax year, the Form 1099 information returns will be based on estimates. If it turns out the RIC s net capital gain income (or exempt-interest income, short-term capital gain income, or interest-related income as the case may be) for its tax year is different than estimated, the RIC is required to provide amended Form 1099 information returns, and its shareholders must file amended tax returns reflecting the proper character of dividends and distributions. The Bill would allow RICs to reduce dividends in the subsequent year by the amount of the excess dividend reported in the prior calendar year. For example, if a RIC makes quarterly distributions of $30,000 on September 30, 2011, December 31, 2011, March 31, 2012, and June 30, 2012, and designates them as capital gain dividends, but has only $100,000 of capital gain income for its tax year ending June 30, 2012, the RIC would report an excess of $20,000 as capital gain dividends. Under the Bill, the RIC would be allowed to reduce the March 31, 2012 and June 31, 2012 capital gain dividends of $60,000 by the $20, excess amount, rather than be required to reduce any of the 2011 capital gain dividend amounts. 16 The provision would apply to tax years beginning after the date of enactment. 2. Amendment to Reduce Earnings and Profits by Nondeductible Expenses (Section 302 of the Bill) RICs generally may reduce their earnings and profits only by amounts that are deductible for tax purposes. 17 The Code places various limitations on deductions associated with tax-exempt interest income. 18 Thus, if a RIC invests in tax-exempt If the RIC s tax year capital gain income were only $40,000, the excess designated amount would be $80,000, which exceeds the amount of the RIC s 2012 capital gain income. In that case, the excess amount would be allocated pro rata to each dividend (i.e., $20,000 to each distribution, resulting in $10,000 of capital gain dividends for each period). Section 852(c)(1). See section 265.

8 Proposed Legislation Would Update the Tax Rules for RICs page 8 bonds, its earnings and profits may be overstated and distributions to its shareholders may be treated as dividends rather than a return of capital, resulting in the shareholders being overtaxed if the RIC incurs expenses that are not deductible for tax purposes. 19 The Bill would remedy this uneconomic result by allowing RICs to reduce their earnings and profits by (1) expenses that are not deductible under section 265, and (2) amortizable bond premium that is not deductible under section 171(a)(2). The Bill also provides that current and accumulated earnings and profits would be adjusted for capital losses in the year the capital losses are deductible for tax purposes. The provision would apply to tax years beginning after the date of enactment. 3. Dividend Pass-thru Rules for Fund-of-Fund Structures (Section 303 of the Bill) Under current law, RICs can pass thru to shareholders exempt-interest dividends and foreign tax credits if at least 50 percent of the value of the RIC s assets consist of tax-exempt obligations (in the case of exempt-interest dividends), 20 or more than 50 percent of the value of the RIC s assets consist of stock or securities in foreign corporations (in the case of the foreign tax credit). 21 Because of these asset requirements, upper-tier RICs in fund-of-funds structures are prevented from passing thru exempt-interest dividends and foreign tax credits because the upper-tier RIC s assets consist of shares in lower-tier RICs, rather than tax-exempt obligations or stock or securities of foreign corporations. In contrast, upper-tier RICs in fund-of-fund structures may pass thru capital gain dividends and qualified dividends received from lower-tier RICs because the pass-thru rules for these items do not have an asset requirement. 22 Thus, under present law, the pass-thru rules relating to distributions made by upper-tier RICs in fund-of-funds structures are different for exempt-interest dividends and foreign tax credits than for capital gain dividends and qualified dividends For example, assume a RIC has $1 million of gross tax-exempt interest and $10,000 of expenses disallowed under section 265, and no other current or accumulated earnings and profits. If the RIC were to distribute $1 million, the entire distribution would be treated as a dividend ($990,000 would be exempt-interest dividends and $10,000 would be ordinary dividends) because the RIC s earnings and profits would be $1 million, even though the RIC s economic income for the year is only $990,000. Section 852(b)(5). Section 853(a). See Sections 852(b)(3) and 854(b)(3).

9 Proposed Legislation Would Update the Tax Rules for RICs page 9 To equalize the treatment, the Bill would amend section 852 to allow certain qualified funds of funds to pay exempt-interest dividends and pass-thru foreign tax credits without regard to the 50-percent-asset requirements described above. To be eligible as a qualified fund of funds, at least 50 percent of the value of a RIC s total assets, measured at the close of each quarter of the RIC s tax year, must be represented by interests in other RICs. 23 The provision would apply to tax years beginning after the date of enactment. 4. Spillover Dividend Declaration and Payment Rules (Section 304 of the Bill) Under current law, a RIC may elect to include in its dividends paid deduction for a tax year certain spillover dividends declared and paid after the close of that tax year if (1) the RIC declares the dividend prior to the due date for filing its tax return for the tax year (the declaration requirement ) and (2) the dividend is paid on or before the date the RIC pays its next regular dividend (or not later than 12 months after the declaration date, if earlier) (the payment requirement ). 24 The payment requirement limits a RIC s flexibility in terms of the timing for distributions. For example, a RIC that desires to make a capital gain distribution would be required to make a spillover dividend first (or contemporaneously) if it wants to include the spillover dividend in computing its dividends paid deduction for the prior tax year. The Bill would allow RICs to time the payment of spillover dividends to match the timing of the payment of the next regular dividend of the same type. 25 Additionally, the declaration requirement would be amended to require spillover dividends to be declared by the later of the 15 th day of the 9 th month following the close of the RIC s tax year, or the extended due date for filing the RIC s tax return. The provision would apply to distributions in tax years beginning after the date of enactment Under the 2009 version of the Bill, the definition of a qualified fund of funds was different and would have required at least 95 percent of the value of a RIC s assets to be represented by cash and cash items (including receivables) and interests in other RICs. Section 855(a). A dividend attributable to short-term capital gain with respect to which a notice is required under the 1940 Act would be treated as the same type of dividend as a capital gain dividend.

10 Proposed Legislation Would Update the Tax Rules for RICs page Allocation of Earnings and Profits (Section 305 of the Bill) In general, RICs can avoid an entity-level income tax, as well as an excise tax under section 4982, if they distribute substantially all of their ordinary income and capital gain to shareholders within certain prescribed time periods. The tax treatment of a distribution, to both a RIC and its shareholders, depends on whether the distribution is a dividend under section 316. In general, a distribution will be a dividend to the extent of the RIC s current or accumulated earnings and profits. Under current law, a RIC s current earnings and profits are allocated pro rata across all distributions made during the tax year. 26 Distributions that exceed current and accumulated earnings and profits are treated as a return of capital under section 301. For non-calendar year RICs, the requirement that current earnings and profits be allocated pro rata across distributions made during the tax year can create difficulties for RICs who endeavor to distribute earnings by December 31 to avoid an excise tax. The allocation rule also makes it difficult for RICs to report the character of its pre-january 1 distributions to shareholders given that earnings and profits and total distributions for the tax year can only be estimated as of December 31. To eliminate these complexities, the Bill would amend section 316 to allow noncalendar year RICs to allocate current earnings and profits to pre-january 1 distributions if distributions for the tax year exceed the RIC s current and accumulated earnings and profits for the tax year. 27 For example, a RIC with a tax year ending June 30 that has current earnings and profits of $4 million (and no accumulated earnings and profits) and that distributes $3 million to shareholders on both September 15 and March 15, would treat all $3 million of the September 15 distribution as a dividend, $1 million of the March 15 distribution as a dividend, and the remaining $2 million as a return of capital. This differs from current law which allocates half of the RIC s $4 million of current earnings and profits to the September 15 distribution and the other half to the March 15 distribution. The provision would apply to distributions made in tax years beginning after the date of enactment Section (b). In the case of a RIC that has more than one class of stock, the amendment would apply separately to each class of stock. See Rev. Rul , C.B. 46.

11 Proposed Legislation Would Update the Tax Rules for RICs page Redemptions (Section 306 of the Bill) RICs that are registered under the 1940 Act and classified as an open-end management investment company must stand ready to redeem their shares from shareholders on demand for an amount equal to the shares net asset value. As a result of this requirement, RICs frequently redeem their shares. Subchapter M does not contain any special rules for the tax treatment of RIC share redemptions. Accordingly, the tax treatment is determined under the general rules in subchapter C for regular corporate stock redemptions. Under subchapter C, when a corporation acquires its stock from a shareholder in exchange for property (including money), the redemption will be treated as an exchange if section 302(b)(1), (2), (3), or (4) applies. In the case of a redemption treated as an exchange, the shareholder will realize gain or loss equal to the difference between its amount realized on the exchange (equal to the amount of money and the fair market value of any property received) and the taxpayer s basis in the redeemed shares. 28 In the context of fund-of-fund structures, losses realized on redemptions treated as exchanges may be deferred under the loss deferral rules of section 267(f). 29 If a redemption is not treated as an exchange under section 302(b), it will be subject to the rules of sections 301 and 316, which generally treat a corporate distribution as a dividend to the extent of the distributing corporation s earnings and profits. 30 As a general matter, section 302(b) examines the effect of a redemption on the redeeming shareholder s relative interest in the redeeming corporation and provides that the following redemptions shall be treated as exchanges: (1) redemptions that are not essentially equivalent to a dividend; (2) substantially disproportionate redemptions; (3) a redemption of all of a shareholder s stock; and (4) noncorporate shareholder partial liquidations See sections 1001(a) and (b). Section 267(f) defers losses realized on an exchange of property between members of a controlled group until the property is transferred outside of the group. In the case of a fund of funds, a lower-tier fund may be required to redeem shares held by an upper-tier fund when the upper-tier fund shareholders demand redemption of their shares. If the upper-tier fund and lower-tier fund are members of a controlled group as defined in section 267(f)(1), any loss realized by the upper-tier fund on redemption of its shares in the lower-tier fund may be deferred. See sections 302(d) and 301(c)(1). If the distribution exceeds the distributing corporation s earnings and profits, any excess will be treated first as reducing the shareholder s basis in its stock and then as gain to the extent of any excess. See sections 301(c)(2) and (3).

12 Proposed Legislation Would Update the Tax Rules for RICs page 12 Under these rules it can be difficult for a RIC to determine whether a redemption of its shares should be treated as an exchange or as a dividend. There may be hundreds of thousands of share redemptions per day and a literal application of section 302(b) would require each individual redemption to be tested under section 302(b). To eliminate this complexity, the Bill would amend section 302(b) to treat redemptions of publicly offered 31 RIC shares as exchanges, unless otherwise provided in regulations, if (1) the redemption occurs upon demand of a shareholder and (2) the RIC issues only shares that are redeemable upon demand of its shareholders. The Bill would also amend section 267(f) to provide that, unless otherwise provided in regulations, the general loss deferral rule of section 267(a)(1) would not apply to losses realized upon redemption of RIC shares if (1) the RIC issues only stock which is redeemable upon demand of its shareholders, and (2) the redemption is upon demand of another RIC. These provisions would apply to redemptions made after the date of enactment. 7. Repeal of Preferential Dividend Rule for Publicly Offered RICs (Section 307 of the Bill) In general, RIC distributions are eligible for the dividends paid deduction under section 561 only if they are not preferential dividends. A dividend will be preferential for this purpose unless it is pro rata, with no preference to any share of stock as compared with other shares of the same class, and with no preference to one class of stock as compared with another class except to the extent that the former is entitled, without reference to waivers of their rights by shareholders, to such preference. 32 If a distribution meets the definition of a preferential dividend, a RIC may be subject to both an income tax and an excise tax on the amount of the dividend. Accordingly, whether a distribution is a preferential dividend can be critical for RICs and its shareholders. The application of the preferential dividend rule frequently presents interpretative and operational difficulties, particularly in the For this purpose, the section 67(c)(2)(B)(i) definition of publicly offered regulated investment company would apply which includes a RIC whose shares 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 year. See sections 562(c) and (a). See sections 562(c) and (a).

13 Proposed Legislation Would Update the Tax Rules for RICs page 13 case of multi-class funds and funds distributed through wrap account arrangements. Many RICs are subject to securities laws administered by the Securities and Exchange Commission. These securities laws provide strict limits on a RIC s ability to issue shares with preferential rights. The Ways and Means Committee explanation of the proposed change notes that the 1940 Act and the Securities and Exchange Commission ensure that investors in mutual funds are treated equally and fairly and that the preferential dividend rule has largely served as an unintended trap for mutual funds that make inadvertent processing or computational errors. 33 Accordingly, the Bill would amend section 562(c) to eliminate the rule prohibiting preferential dividends for publicly offered RICs. 34 The provision would apply to distributions made in tax years beginning after the date of enactment. 8. Elective Deferral of Certain Late-Year Losses and Increase in Required Distribution of Capital Gain Net Income (Sections 308, 402, and 404 of the Bill) In general, a RIC will be subject to a four percent excise tax under section 4982 if it does not distribute at least 98 percent of its ordinary income for the calendar year, 98 percent of its capital gain net income for the one-year period generally ending on October 31, and any previously undistributed ordinary income and capital gain net income from prior calendar years. 35 For purposes of section 4982, a RIC is treated as distributing an amount to its shareholders equal to the sum of (1) its deduction for dividends paid during the calendar year under section 561 and (2) the amount on which a corporate income tax is imposed under section 852 for tax years ending during the calendar year. In general, distributions are eligible for the dividends paid deduction only if they are dividends described in section 316 (i.e., they are distributions of current and accumulated earnings and profits) and are not preferential dividends. 36 RICs may also pay capital gain dividends to their shareholders to the extent of net capital gain for the tax year. For non-calendar year RICs, net capital gain for the tax year will not be known until after the end of the calendar year. For example, capital Committee on Ways and Means, H.R. 4337: Regulated Investment Company Modernization Act of 2009 (Dec. 16, 2009). See note 31 supra with respect to the definition of publicly offered RIC. Sections 4982(a) and (b). See sections 562(a), 562(c), and (a).

14 Proposed Legislation Would Update the Tax Rules for RICs page 14 losses realized after the end of the calendar year but before the end of the tax year could cause pre-january 1 distributions that were designated as capital gain dividends to be incorrectly reported to shareholders and could also subject RICs to an excise tax obligation (absent special rules discussed below). The same result can occur with respect to ordinary losses arising after the end of the calendar year but before the end of the RIC s tax year. 37 Because of these issues, current law provides that, for purposes of characterizing dividends paid to shareholders, capital losses arising after October 31 may be treated as arising on the first day of the RIC s next tax year. 38 A RIC also may elect to push forward certain capital losses for purposes of determining its taxable income. 39 Similar push-forward rules apply to late-year net foreign currency gains and losses and ordinary gains and losses arising from the disposition of stock in a passive foreign investment company ( PFIC ). 40 The rules apply automatically for excise tax purposes and are elective for income tax purposes. 41 These automatic and elective push-forward rules do not apply to ordinary losses other than foreign currency losses and PFIC stock losses. Thus, the character of pre-january distributions may be affected by late-year ordinary losses that reduce earnings and profits for the tax year. To address these issues, the Bill would amend section 852(b)(8) to allow RICs to elect to treat all or a portion of any qualified late-year capital or ordinary loss as arising on the first day of the following tax year, unless otherwise provided by regulations. The election would apply for all purposes of the Code, including For example, a RIC with a June 30 tax year could pay a capital gain dividend in December 2010 equal to 98 percent of a $1,000,000 long-term capital gain the RIC recognized in September If the RIC subsequently recognizes a capital loss in January 2011 of $600,000 and has no other current or accumulated earnings and profits, the RIC s net capital gain for its tax year would be only $400,000. Thus, only $400,000 of the $980,000 distribution paid to the RIC s shareholders in 2010 would be a capital gain dividend. The remaining $580,000 would be a return of capital. Accordingly, the RIC would be required to issue amended information returns to the shareholders reflecting the reduced amount of the distribution that constitutes a dividend. Furthermore, for excise tax purposes, the RIC would be treated as distributing only $400,000, the amount eligible for the dividends paid deduction under section 561, whereas its capital gain net income for the one-year period ending October 31, 2010, would be $1,000,000. Accordingly, the RIC would be subject to an excise tax on $580,000. Sections 852(b)(3)(C) and Thus, in the example in the previous footnote, the $600,000 capital loss realized in January 2011 would be treated as arising on July 1, Section Sections 4982(e)(5) and (6). Sections 4982(e)(5), 4982(e)(6), 852(b)(8), 852(b)(10), and

15 Proposed Legislation Would Update the Tax Rules for RICs page 15 computing a RIC s taxable income, net capital gain, and earnings and profits for the tax year. A qualified late-year loss for this purpose would mean any Post-October capital loss (defined as the greater of the post-october net capital loss, net long-term capital loss, or net short-term capital loss) and Late-year ordinary loss (defined as the excess of (1) post-december 31 ordinary losses over ordinary income from the same period and (2) foreign currency losses arising between November 1 and December 31 over foreign currency gains arising during the same period). 42 The Bill would also amend the excise tax rules to allow specified late-year losses to be pushed forward to the following calendar year for purposes of calculating a RIC s excise tax obligation, unless otherwise provided by regulations. These provisions would be effective for tax years beginning after the date of enactment. Finally, the Bill would increase the required distribution percentage of capital gain net income from 98 percent to 98.2 percent. This provision would apply to calendar years beginning after the date of enactment. 9. Timing of Deemed Distributions (Section 403 of the Bill) Under current law, RICs that expect to pay income tax are required to make estimated income tax payments. For excise tax purposes, RICs are treated as distributing amounts to shareholders equal to the income upon which they pay income tax. This income is not treated as a distributed amount for excise tax purposes, however, until the end of the RIC s tax year. Thus, if a RIC has a tax year other than the calendar year, the RIC will not be treated as making a distribution of taxable income for excise tax purposes until the following calendar year. Thus, the RIC may be subject to an excise tax. The Bill would amend section 4982(c) to allow non-calendar year RICs to elect to treat the amount upon which qualified estimated tax payments are made during the calendar year as a distributed amount in that calendar year. This provision would apply to calendar years beginning after the date of enactment. 42 Special rules would apply to RICs with tax years ending in November or December.

16 Proposed Legislation Would Update the Tax Rules for RICs page Deficiency Dividends (Section 501 of the Bill) RICs that fail to distribute their investment company taxable income may make a deficiency dividend in the subsequent tax year. 43 The deficiency dividend is treated as a deductible dividend paid in the prior tax year and eliminates the RIC s tax deficiency for that year. Under current law, RICs are subject to both an interest charge and a penalty on the amount of the deficiency dividend. 44 REITs are similarly allowed to make deficiency dividends and are similarly subject to an interest charge. REITS are not, however, subject to a penalty. To conform the RIC rules to the rules for REITs, section 6697 would be amended to eliminate the penalty (but not the interest charge) imposed on deficiency dividends paid by RICs. The provision would apply to tax years beginning after the date of enactment. 11. Holding Period Requirement for Exempt-Interest Dividends (Section 309 of the Bill) Under section 852(b)(4)(B), losses incurred by a RIC shareholder on the sale or exchange of RIC stock held for six months or less may be limited to the extent the shareholder received an exempt-interest dividend prior to the sale or exchange. The Bill would turn off this loss disallowance rule (except as otherwise provided in regulations) for regular dividends paid by a RIC provided the RIC (1) declares exempt-interest dividends on a daily basis in an amount equal to at least 90 percent of its net tax-exempt interest and (2) distributes the dividends on at least a monthly basis. The provision would apply to stock for which the taxpayer s holding period begins after the date of enactment. 12. Dividend Designation Rules (Section 301 of the Bill) Under current law, RICs are required to send a written designation to shareholders within 60 days of the end of the RIC s tax year notifying the shareholders of the tax treatment of various distributions made by the RIC during its tax year (e.g., capital gain dividends, exempt-interest dividends). This requirement predates the comprehensive Form 1099 information reporting rules that require RICs to provide shareholders with similar information. The Bill would eliminate this duplicative requirement. The provision would apply to tax years beginning after the date of enactment Section 860. Section 6697.

17 Proposed Legislation Would Update the Tax Rules for RICs page 17 C. Miscellaneous Amendments The Bill would also make the following additional amendments. 1. Unlimited Capital Loss Carryovers (Section 101 of the Bill) Under current law, taxpayers, including RICs, are generally entitled to deduct capital losses only to the extent of the taxpayer s capital gains for the year. 45 Any excess losses may be carried forward (and, in some cases, back) and used to offset capital gains realized in future (or prior) years. Under current law, RICs may carry forward capital losses for eight years. This differs from the treatment afforded individual investors who may carry forward capital losses indefinitely. The Bill would amend section 1212 to put RICs on equal footing with individuals by allowing RICs unlimited capital loss carryovers. The Bill would also characterize capital loss carryovers as long-term capital losses to the extent net long-term capital losses exceed short-term capital gain. 46 The provision would apply to net capital losses arising in tax years beginning after the date of enactment Tax-Exempt Shareholders (Section 401 of the Bill) Under current law, RICs that are wholly owned by certain tax-exempt shareholders are exempt from the section 4982 excise tax. The Bill would amend section 4982 to expand the types of shareholders a RIC may have to qualify for this exemption from the excise tax. The expanded list of shareholders would include qualified annuity plans, traditional and Roth IRAs, certain government plans described in sections 414(d) and 457, section 501(c)(18) pension plans, and RICs that are themselves exempt from the excise tax as a result of having tax-exempt shareholders. The provision would apply to calendar years beginning after the date of enactment Section Under the Bill, the excess of a RIC s short-term capital loss over its net long-term capital gain (if any) would be treated as short-term capital loss arising on the first day of the next tax year, and the excess of its net long-term capital loss over its net short-term capital gain (if any) would be treated as long-term capital loss arising on the first day of the next tax year. Thus, the Bill would allow for unlimited capital loss carryovers and would characterize certain carryovers as long-term capital losses. Under a transition rule, the present-law rules that limit carryovers to eight years and treat all carryovers as short-term capital losses would continue to apply to losses arising in tax years beginning on or before the date of enactment.

18 Proposed Legislation Would Update the Tax Rules for RICs page Capitalized Load Charges (Section 502) Under section 852(f), RIC shareholders are in some cases required to capitalize into the basis of their RIC shares certain load charges incurred in connection with the purchase of the shares. If a shareholder disposes of its RIC stock within a prescribed time period, these load charges may be required to be carried over and capitalized into the basis of new RIC shares that are subsequently acquired. The requirement that the load charges carry over can be administratively burdensome for shareholders and RICs if there is a delay between the date the initial shares are disposed and the date the new shares are acquired. To address this, the Bill would amend section 852(f) to require capitalized load charges to carry over to newly acquired RIC stock only if the new stock is acquired before January 31 of the calendar year following the year in which the original RIC stock is disposed. The provision would apply to charges incurred in tax years beginning after the date of enactment. III. Conclusion The Joint Committee on Taxation estimates that the Bill would raise $30 million over 10 years. 48 The Bill goes to the Senate, whose leaders have not indicated whether they intend to consider it during the lame-duck session in November. If the Senate does not act on the Bill, proponents would have to reintroduce it next year. KPMG s What's News in Tax is a publication from Washington National Tax that contains thoughtful analysis of new developments and practical, relevant discussions of existing rules and recurring tax issues. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author(s) only, and does not necessarily represent the views or professional advice of KPMG LLP. 48 Joint Committee on Taxation publication JCX (Estimated Revenue Effects of H.R. 4337) (Sept. 28, 2010).