An Analysis of the Regulated Investment Company Modernization Act of 2010

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1 January 2011 / Issue 1 A legal update from Dechert s Financial Services Group An Analysis of the Regulated Investment Company Modernization Act of 2010 d Summary The Regulated Investment Company Modernization Act of 2010, P.L (the Act ), was signed into law by President Obama on December 22, 2010 (the Date of Enactment ). 1 The Act makes a number of changes to the provisions in the Internal Revenue Code of 1986, as amended (the Code ) relating to regulated investment companies ( RICs ), that will generally become effective for taxable years of RICs beginning after the Date of Enactment. This update summarizes the Act and also includes a more detailed explanation and analysis of each of the provisions in the Act. It should be noted that the final version of the Act does not include a provision contained in prior versions of the Act that would have expanded the RIC qualifying income test to include income and gains from investments in commodities and derivatives on commodities as qualifying income. The Act also does not include a related provision contained in prior versions of the Act that would have removed the U.S. Treasury s regulatory authority to restrict certain foreign currency gains under the RIC qualifying income test. The changes made by the Act include: repeal of the preferential dividend rule for distributions made by publicly offered RICs; 1 The Act was approved by the U.S. Senate on December 8, 2010 and by the U.S. House of Representatives on December 15, allowing a cure, through payment of a monetary penalty, for a failure to satisfy the RIC qualifying income requirement where the failure is due to reasonable cause; allowing certain cures for a failure to satisfy the RIC diversification requirements where the failure is de minimis, or through payment of a monetary penalty where certain diversification failures are due to reasonable cause; allowing RICs to generally carryover net capital losses indefinitely (retaining their character as either long-term capital losses or short-term capital losses), effective for losses arising in taxable years beginning after the Date of Enactment; an increase from 98% to 98.2% in the amount of capital gain net income taken into account in determining the amount of distributions necessary to avoid excise tax under Section 4982; 2 modification of the designation requirements, with respect to the flowthrough to shareholders of the character of certain items of income and gains earned by a RIC, to allow reports in written statements furnished to shareholders that can include Form 1099s; changes in the rules for allocation of earnings and profits (and returns of capital) among multiple distributions made with respect to a RIC s taxable year; 2 Unless indicated otherwise, references to Sections are to Sections of the Code.

2 changes in certain rules relating to the payment of spillover dividends; allowing pass-through of exempt-interest dividends and foreign tax credits from underlying RICs in a fund of funds structure; clarifying that a redemption of shares in a publicly offered open-end RIC is treated as a sale or exchange transaction; clarifying that certain loss deferral rules are not applicable to redemptions by a fund of funds, of shares in an underlying fund; modification of the rule that limits the deductibility of capital losses on sales and/or redemptions of RIC shares after the payment of an exempt interest dividend; changes in the rules relating to the deferral of certain losses for purposes of determining taxable income and capital gains; changes in the rules relating to the deferral of certain losses for purposes of determining required distributions under the excise tax; modification of the treatment of capital losses in determining earnings and profits; modification of the treatment of expenses of RICs paying exempt-interest dividends in determining earnings and profits; expansion of the types of entities that can own a RIC under the exemption from the excise tax; certain technical changes in the excise tax provisions; modification of the rules for deferring certain losses on sales of RIC shares, that are attributable to sales loads, where shares in the same or another RIC are subsequently acquired with a reinvestment right; and repeal of the additional penalty that was applicable on payments of a deficiency dividend by RICs. It should also be noted that the recently enacted Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, 3 which was the subject of 3 P.L d an earlier update, 4 also contains provisions that are relevant to RICs, including: an extension of the 2010 tax rates on long-term capital gains and qualified dividends for a period of two years, through 2012; an extension of the current 28% rate for backup withholding, through 2012; an extension of the ability of RICs to pass through the character of U.S. source net interest income and net short-term capital gains to non- U.S. shareholders, through taxable years of a RIC beginning before January 1, 2012; an extension of the treatment of RICs as qualified investment entities for purposes of the FIRPTA rules, through December 31, 2011; an extension of a look-through rule under the estate tax for RIC stock held by non-u.s. shareholders for estates of decedents dying before January 1, Background: Overview of RICs An investment company registered under the Investment Company Act of 1940, as amended (the 1940 Act ), may elect to be taxed as a RIC, under the provisions in Subchapter M of the Code, for any taxable year in which it satisfies certain requirements relating to the source of its income and the diversification of its assets. A RIC that satisfies certain additional minimum distribution requirements is generally allowed to deduct the amount of dividends paid to its shareholders in computing the RIC s taxable income and gains, with the result that the RIC s distributed net income and gains can be passed through to its shareholders free of tax at the RIC level. A RIC can pass through the character of its long-term capital gain income to its shareholders by paying capital gain dividends and, in certain circumstances, the character of tax-exempt interest income can also be passed through to the shareholders on the payment of exempt-interest dividends. Under certain conditions, a RIC may also pass through to its shareholders the ability, subject to certain limitations, to take the foreign 4 January 2011 DechertOnPoint Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 Approved by Congress and Signed by the President. January 2011 / Issue 1 2

3 tax credit (or deduction) with respect to foreign taxes paid by the RIC. A RIC may also pass through to its shareholders the character of qualified dividend income and dividends eligible for the corporate dividends received deduction. Under a temporary provision, RICs may also pass-through the character of net short-term capital gains and U.S. source net interest income to foreign shareholders. Repeal of the Preferential Dividend Rule for Distributions by Publicly Offered RICs The Act repeals the preferential dividend rule for distributions by publicly offered RICs, for taxable years of RICs beginning after the Date of Enactment. Potential restrictions under the 1940 Act would still apply. In determining the amount of investment company taxable income and taxable net capital gain, RICs are generally allowed a deduction for dividends paid to their shareholders. Prior to the Act, the dividends paid deduction was generally disallowed for so-called preferential dividends. 5 For this purpose, a dividend is generally preferential unless it is distributed pro rata to shareholders. The preferential dividend rule has required that all shareholders in a RIC be charged the same rate of management fees, custody fees and other fund-wide expenses. 6 The Internal Revenue Service ( IRS ) has allowed differences in distributions among classes of a RIC that reflect differences in 12b-1 fees and/or certain types of class level expenses. 7 The IRS has also provided specific rules for waivers and reimbursements of fees and expenses under the preferential dividend rule. 8 The preferential dividend rule has been a trap that could result in severe tax consequences in situations where there were differences in distributions that were not in accordance with IRS rules, even when the 5 Section 562(c). difference was caused by a miscalculation or other inadvertent error. The Act repeals the preferential dividend rule for publicly offered RICs, effective for distributions in taxable years of RICs beginning after the Date of Enactment. For this purpose, a publicly offered RIC is a RIC whose shares are: continuously offered pursuant to a public offering (within the meaning of Section 4 of the Securities Act of 1933); regularly traded on an established securities market; or held by or for no fewer than 500 persons at all times during the taxable year. 9 Comments: The preferential dividend rule will continue to apply to RICs that are not publicly offered under the above definition. Even after the repeal of the preferential dividend rule for publicly offered RICs, all RICs are still subject to restrictions under the 1940 Act, including those in Section 18 of the 1940 Act (relating to senior securities) and Rule 18f-3 under the 1940 Act. 10 The rules for allocating fees and expenses in multiple class funds, and the rules for waiving expenses, under Rule 18f-3 are similar to the IRS rules for such allocations and waivers under the preferential dividend rule. Because RICs will still need to comply with the provisions and rules under the 1940 Act, as a practical matter, the repeal of the preferential dividend rule should not change the general rules relating to fees and expenses of multiple class funds. Other situations that were potentially impacted by the preferential dividend rule will also need to be analyzed in the context of the provisions and rules under the 1940 Act. The Act did not repeal the preferential dividend rule for real estate investment trusts ( REITs ) and other types of entities otherwise eligible for the dividends paid deduction. 6 Rev. Proc , C.B. 338, as modified by Rev. Proc , I.R.B Id. 9 See Section 67(c)(2)(B) CFR f-3. 8 Rev. Proc , I.R.B January 2011 / Issue 1 3

4 Provisions Relating to the Qualifying Income Requirement Proposal to Expand the Qualifying Income Test to Include Investments in Commodities Not Included in the Act The final version of the Act does not include a provision contained in prior versions of the Act that would have expanded the RIC qualifying income test to include income and gains from investments in commodities and derivatives on commodities as qualifying income. The Act also does not include a related provision contained in prior versions of the Act that would have removed the U.S. Treasury s regulatory authority to restrict certain foreign currency gains under the qualifying income test. A RIC must derive at least 90% of its gross income for a taxable year from certain types of income (the qualifying income test ). These types of income ( qualifying income ) are (1) dividends, interest, payments with respect to securities loans (as defined in Section 512(a)(5)), and gains from the sale or other disposition of stock or securities (as defined in Section 2(a)(36) of the 1940 Act) or foreign currencies, or other income (including but not limited to gains from options, futures or forward contracts) derived with respect to the business of investing in such stock, securities, or currencies, and (2) net income derived from an interest in a qualified publicly traded partnership. 11 In general, investments in commodities do not generate qualifying income for purposes of the qualifying income test. Further, the IRS has also ruled that income or gains from derivative contracts with respect to commodity indexes are not qualifying income for purposes of the qualifying income test. 12 On the other hand, in a series of private rulings, the IRS has held that structured notes with certain features, that have payout formulas determined with reference to a commodities index, produce qualifying income for purposes of the qualifying income test. 13 The IRS has also held, in private letter rulings, that income of a RIC derived from investments in commodities by a wholly 11 Section 851(b)(2). 12 Rev. Rul , I.R.B. 1, modified by Rev. Rul , I.R.B See e.g., PLR d owned foreign subsidiary of the RIC is qualifying income for purposes of the qualifying income test. 14 Note: Although a private letter ruling may express the position of the IRS on an issue at the time the ruling was issued, only the taxpayer that obtains a private letter ruling may actually rely on such a ruling. Although gains from foreign currencies and derivatives on foreign currencies are included as qualifying income under Section 851(b)(2), the Treasury has regulatory authority to exclude from qualifying income certain foreign currency gains which are not directly related to a RIC s principal business of investing in stock or securities (or options and futures with respect to stock or securities). 15 Prior versions of the Act would have modified the qualifying income test to provide that (i) a RIC s gains from the sale or other disposition of commodities and (ii) other income of a RIC (including but not limited to gains from options, futures or forward contracts) derived with respect to its business of investing in commodities, would be qualifying income. Because foreign currencies are commodities, prior versions of the Act would have also removed the regulatory authority given to the Treasury to exclude certain foreign currency gains from qualifying income. Although the House of Representatives approved the expansion of the qualifying income test to include direct investments in commodities (and derivatives on commodities) as qualifying income, a few Senators raised questions about the potential effect of the provision and asked for further study. As a result, the provision was dropped from the final version of the Act approved by the Senate in the interest of having the Act approved in a timely manner. Comments: RICs are still able to invest directly in commodities or commodities derivatives as long as the RIC derives no more than 10% of its gross income from such items (in addition to any other non-qualifying income). For this purpose, because the test is based on gross income, gains are taken into account and losses are not included in the calculation, which can make it difficult to insure compliance with the 10% limit. As discussed above, some RICs have obtained private letter rulings that income and gains from investments 14 See e.g., PLR Section 851(b). January 2011 / Issue 1 4

5 in certain commodity linked structured notes are qualifying income. Investments in such structured notes can result in credit risks, additional costs and embedded fees. Investments in commodities and derivatives on commodities, through a wholly owned foreign subsidiary of a RIC, also entail additional costs and such a structure is also generally not tax efficient because the subsidiary would be subject to tax provisions in the Code relating to controlled foreign corporations. Cure for Failure to Satisfy the Qualifying Income Test As discussed above, a RIC must derive at least 90% of its annual gross income from certain qualifying sources. Prior to the Act, if a RIC derived, in a taxable year, more than 10% of its gross income from nonqualifying sources, it was not eligible for taxation as a RIC and would be treated as a regular C corporation. This would normally result in corporate level tax and an inability to pass through the character of long-term capital gains and other items to shareholders. The Act allows a RIC to cure a failure to satisfy the RIC qualifying income requirement, through the payment of a monetary penalty, if the failure is due to reasonable cause and not willful neglect. This provision applies to taxable years with respect to which the due date of the tax return (determined with regard to extensions) is after the Date of Enactment. As discussed above, a RIC must derive at least 90% of its gross income for a taxable year from certain types of qualifying income. These types of income are (1) dividends, interest, payments with respect to securities loans (as defined in section 512(a)(5)), and gains from the sale or other disposition of stock or securities (as defined in section 2(a)(36) of the 1940 Act) or foreign currencies, or other income (including but not limited to gains from options, futures or forward contracts) derived with respect to the business of investing in such stock, securities, or currencies, and (2) net income derived from an interest in a qualified publicly traded partnership. 16 Note: Because the qualifying income requirement is based on the RIC s gross income from particular sources, gains on the sale of assets are taken into 16 Section 851(b). account, without regard to losses from the sale of assets. The Act amends Section 851(b) to provide that a RIC that fails to meet the qualifying income test shall nevertheless be considered to have satisfied the test, if: (i) following the RIC s failure to meet the test for the taxable year, the RIC sets forth in a schedule, filed in the manner provided by the Treasury, a description of each item of its gross income, and (ii) the failure to meet the qualifying income test is due to reasonable cause and is not due to willful neglect. In addition, a tax would be imposed on any RIC that fails to meet the qualifying income test and which relies on the cure provision. Such tax would be equal to the amount by which the RIC s gross income from sources which are not qualifying income exceeds one-ninth of its gross income from sources which are qualifying income. Example: If a RIC has $90 million of gross income from sources which are qualifying income and $13 million of gross income from other sources, a tax of $3 million would be imposed pursuant to the cure provision. Taxes imposed in connection with curing a failure to satisfy the qualifying income test are deductible for purposes of calculating a RIC s investment company taxable income. The provision applies to taxable years of a RIC with respect to which the due date of the RIC s tax return (determined with regard to extensions) is after the Date of Enactment. Comments: Because the penalty under the cure provision is based on non-qualifying gross income (in excess of one-ninth of qualifying income), which includes gains, and not losses, in some cases the penalty could be substantial. In situations where a RIC is relying on the cure provision, questions will arise as to whether there was reasonable cause for failing the qualifying income test under particular facts and circumstances. Sections 856(c)(6) and 856(c)(7) provide similar cure provisions for REITs that fail to satisfy certain qualification requirements for REITs. A Treasury Regulation relating to the REIT cure provisions provides that the reasonable reliance on a reasoned, written opinion as to the characterization of gross income to be derived (or being derived) from a transaction generally constitutes reasonable cause if income from the transaction causes a failure to meet the REIT requirements. 17 The Regulation goes on to provide 17 Treas. Reg. Section (c)(2). January 2011 / Issue 1 5

6 that the absence of such a reasoned, written opinion does not, by itself, give rise to any inference that the failure was without reasonable cause. 18 Cure for Failure to Satisfy the RIC Diversification Requirements The Act allows a RIC to cure a failure to satisfy the RIC diversification requirements if the failure is de minimis. Certain other diversification failures can be cured through the payment of a monetary penalty if the failure is due to reasonable cause and not willful neglect. In general, Section 851(b)(3) provides certain diversification tests that must be satisfied by a RIC in order to qualify for taxation under Subchapter M of the Code. Under the first test, at the close of each quarter of the taxable year, at least 50% of the value of a RIC s total assets must be represented by (i) cash and cash items (including receivables), Government securities and securities of other RICs, and (ii) other securities, generally limited in respect of any one issuer to an amount not greater in value than 5% of the value of the total assets of the RIC and not more than 10% of the outstanding voting securities of such issuer. Under the second diversification test, at the close of each quarter of the taxable year, not more than 25% of the value of a RIC s total assets may be invested in (i) the securities (other than Government securities or the securities of other RICs) of any one issuer, (ii) the securities (other than the securities of other RICs) of two or more issuers which the taxpayer controls and which are determined, under regulations prescribed by the Treasury, to be engaged in the same or similar trades or businesses or related trades or businesses, or (iii) the securities of one or more qualified publicly traded partnerships (as defined in Section 851(h)). Prior to the Act, Section 851(d) contained two rules that could limit or provide relief from failures to satisfy the diversification requirements. Under the first rule, a RIC that meets both diversification tests at the close of any quarter will not lose its status as a RIC because of a discrepancy during a subsequent quarter between the value of its various investments and the diversification test requirements, unless such discrepancy exists immediately after the acquisition of any security or other property and is wholly or partly the result of such 18 Id. acquisition. This rule (often called the fluctuation in value exception ) protects a RIC against inadvertent failures of the asset tests that may be caused solely by fluctuations in the relative values of its assets. 19 Under a second rule in Section 851(d) (the 30-day rule ) a RIC can cure a failure to satisfy the diversification tests at the end of a quarter if the discrepancy in satisfying the test is eliminated within 30 days after the quarter. Prior to the Act, if a fund failed the RIC diversification tests (taking into account the fluctuation in value exception) and if such failure was not corrected within the 30-day cure period, the fund would have been subject to corporate level tax on net income and net gains and would not be able to pass through the character of income and gains to its shareholders. The Act provides an additional special rule for de minimis diversification test failures, as well as a mechanism by which a RIC can cure certain other diversification test failures and pay a penalty tax. The rule for de minimis diversification test failures applies if a RIC fails to meet one of the diversification tests in Section 851(b)(3) due to the ownership of assets the total value of which does not exceed the lesser of (i) 1% of the total value of the RIC s assets at the end of the quarter for which the assets are valued, and (ii) $10 million. Where the de minimis rule applies, the RIC shall nevertheless be considered to have satisfied the diversification tests if, within six months of the last day of the quarter in which the RIC identifies that it failed the diversification tests (or such other time period provided by the Treasury) the RIC: (i) disposes of assets in order to meet the diversification requirements, or (ii) otherwise meets the diversification requirements. In the case of other diversification test failures that are not de minimis (except as discussed below), a RIC shall nevertheless be considered to have met the requirements if: (i) the RIC sets forth in a schedule filed in the manner provided by the Treasury a description of each asset that causes the RIC to fail to satisfy the diversification tests; (ii) the failure to meet the diversification tests is due to reasonable cause and not due to willful neglect; and (iii) within six months of the last day of the quarter in which the RIC identifies that it failed the diversification tests (or such other time period provided by the Treasury) the RIC (a) disposes of 19 The IRS has held that the fluctuation in value exception does not apply at the end of a RIC s first taxable quarter in the first year for which an election is made to be taxed as a RIC. Rev. Rul , C.B January 2011 / Issue 1 6

7 the assets which caused the diversification test failure, or (b) otherwise meets the diversification requirements. In cases of diversification test failures other than de minimis failures, the new cure provision imposes a tax in an amount equal to the greater of (i) $50,000 or (ii) the amount determined (pursuant to regulations promulgated by the Treasury) by multiplying the highest rate of tax specified in Section 11 (currently 35%) by the amount of net income generated during the period of diversification test failure by the assets that caused the RIC to fail the diversification test. These provisions added by the Act do not apply to any quarter in which status of a RIC is preserved under the provisions of Section 851(d) (i.e., the 30-day rule or the fluctuation in value exception). Note also that there is no monetary penalty for failures to satisfy the diversification tests that are corrected under the 30-day rule, or for de minimis failures. Taxes imposed in connection with curing a failure to satisfy the diversification tests are deductible for purposes of calculating a RIC s investment company taxable income. These cure provisions apply to taxable years of a RIC with respect to which the due date of the RIC s tax return (determined with regard to extensions) is after the Date of Enactment. Note: The cure provision for diversification failures that are not de minimis does not apply to a diversification failure arising from the investment of more than 25% of the RIC s total assets in the securities (other than U.S. government securities or the securities of other RICs) of any one issuer. Such a failure (that is not subject to the fluctuation in value exception) could still be corrected under the 30-day rule or under the de minimis cure provision. Comments: In situations where a RIC is relying on the cure provision, questions will arise as to whether there was reasonable cause for failing the diversification tests under particular facts and circumstances. There is some degree of uncertainty in determining the issuer and valuation of certain derivatives under the diversification tests. It would clearly be helpful to monitor compliance and to consider the potential treatment of particular investments under the diversification tests. There may be some ambiguity in trying to identify specific assets that caused a failure to satisfy the diversification tests at the end of a quarter, for purposes of the cure provisions, in light of the interaction with the fluctuation in value exception. RICs typically have significant turnover in assets and the percentage of a RIC s assets invested in a particular issuer can also be affected by redemptions of shares in the RIC, payment of liabilities, and by the reduction in the value of other assets. The Act does not provide a cure for a RIC failing to satisfy the diversification requirements under Section 817(h) that apply to RICs that act as underlying investments for variable insurance contracts. The IRS has issued procedures by which an issuer of a variable contract may remedy an inadvertent failure of a variable contract to satisfy the diversification requirements under Section 817(h) upon the payment of monetary penalties, which could be substantial. 20 Modification of Rules Relating to Capital Loss Carryovers The Act allows RICs to generally carryover net capital losses indefinitely, effective for losses arising in taxable years beginning after the Date of Enactment. Such losses will retain their character as either long-term capital losses or short-term capital losses. For losses in taxable years prior to the Act, a RIC is generally able to carryover net capital losses for a period of eight taxable years following the loss year and such carryover is treated as a short-term capital loss in each of those years. 21 In contrast, individual taxpayers are generally able to carryover capital losses indefinitely and such carryovers retain their character as either long-term or short-term capital losses. The Act provides capital loss carryover treatment for RICs similar to the treatment of capital loss carryovers applicable to individuals. Under the Act, capital loss carryovers arising in a RIC s taxable years beginning after the Date of Enactment can be carried forward indefinitely and such carryovers will retain their character as either long-term or short-term capital losses. Thus, under the Act, if a RIC has a net capital loss for a taxable year beginning after the Date of Enactment, the excess (if any) of the net short-term capital loss over the net long-term capital gain is treated as a short-term 20 Rev. Proc , I.R.B Section January 2011 / Issue 1 7

8 capital loss arising on the first day of the next taxable year, and the excess (if any) of the net long-term capital loss over the net short-term capital gain is treated as a long-term capital loss arising on the first day of the next taxable year. Loss carryovers from years beginning prior to the Date of Enactment will still expire subject to the eight-year limitation. The Act provides for the coordination of losses arising in taxable years beginning both prior to and after the Date of Enactment, that would generally require that losses arising in taxable years after the Date of Enactment (which are carried forward indefinitely) would be used prior to loss carryovers arising in taxable years beginning prior to the Date of Enactment. Comments: Although the indefinite carryover of capital losses is clearly beneficial to a RIC and its shareholders, the treatment of long-term capital loss carryovers as long-term capital losses in subsequent years (as distinguished from prior law treatment of carryovers as short-term capital losses) could, in certain cases, result in higher distributions of shortterm capital gains (generally taxed as ordinary income to shareholders) in years to which losses are carried, since long-term capital losses are first applied against long-term capital gains. The ability to utilize capital losses carryovers arising both before and after the Act is still potentially subject to annual limitations pursuant to the rules contained in Sections 382 and 383, in situations where there is an ownership change resulting from an increase in the percentage ownership by shareholders owning 5% or more of a RIC (taking into account certain aggregation rules) of more than 50 percentage points over a specified testing period. These rules can also apply to limit the use of unrealized losses above certain thresholds. These limitations can apply after reorganizations and after certain other ownership shifts by shareholders owning 5% or more of the RIC s shares. Section 384 also contains restrictions, in connection with certain reorganizations, on the use of certain preacquisition losses against certain built-in gains. The rules in Sections 382, 383 and 384 (and other rules in Section 381) are complex. The potential application of these rules to capital losses carryovers both prior to and after the effective date of the Act, taking into account the differing rules for the character of carryovers, and the coordination of losses arising prior to and after the Act, could present challenges in monitoring and tracking capital losses. Additional complexities can be caused by the application of the post-october loss rules, discussed below. Capital losses carryovers and potential limitations on the use of such capital loss carryovers will also be relevant in computing the RIC s capital gain net income (generally measured through October 31) for purposes of determining the required distributions necessary to avoid excise tax under Section Increase in the Required Distribution Under the Excise Tax Effective for calendar years beginning in 2011, the Act increases the annual required distribution under Section 4982 by increasing the percentage of capital gain net income from 98% to 98.2%. Unless an applicable exception applies, Section 4982 imposes a nondeductible 4% excise tax on RICs to the extent that a RIC does not satisfy certain minimum distribution requirements during a calendar year. Prior to the Act, the required minimum distribution was generally equal to the sum of 98% of the RIC s ordinary income (generally computed on a calendar year basis), plus 98% of the RIC s capital gain net income (generally computed for the year period ending on October 31). The amount that must be distributed is generally increased by undistributed income and gains from prior years. Effective for calendar years beginning in 2011, the Act increases the annual required distribution under Section 4982 through an increase in the percentage of capital gain net income from 98% to 98.2%. As a result, the required minimum distribution will generally be equal to the sum of (i) 98% of the RIC s ordinary income (generally computed on a calendar year basis), plus (ii) 98.2% of the RIC s capital gain net income (generally computed for the year period ending on October 31) and (iii) undistributed income and gains from prior years. Comment: The increase in the required distribution under Section 4982 was added to the Act as a revenue raiser to offset other provisions in the Act that were projected to result in revenue losses. January 2011 / Issue 1 8

9 Modification of Designation Requirements The Act replaces the 60-day designation requirement for the pass through of the character of certain types of income and gains by a RIC to its shareholders with a requirement that such passed-through items must instead be reported in written statements to shareholders that can include Form 1099s. A RIC is able to pass through the character of certain types of income or gains earned by the RIC when it makes distributions of such items to its shareholders. A RIC can pass through the character of its long-term capital gain income to its shareholders by paying capital gain dividends and, in certain circumstances, the character of tax-exempt interest income can also be passed through to the shareholders on the payment of exempt-interest dividends. Under certain conditions, a RIC may also pass through to its shareholders the ability, subject to certain limitations, to take the foreign tax credit (or deduction) with respect to foreign taxes paid by the RIC. A RIC may also pass through to its shareholders the character of qualified dividend income and dividends eligible for the corporate dividends received deduction. Under a temporary provision, RICs may also pass through the character of net short-term capital gains and U.S. source net interest income to foreign shareholders. Prior to the Act, a RIC was able to pass-through the character of the above items through designations in a written notice mailed to its shareholders not later than 60 days after the close of the RIC s taxable year. RICs have typically made such designations in annual reports which are normally mailed to shareholders within 60 days after the end of an investment company s fiscal year. RICs are also generally required to report, and designate the character of distributions to shareholders during each calendar year, on Form 1099s that are normally sent in January or early February. The Act eliminates the 60-day deadline and replaces the designation requirement with a requirement that the character of certain items be reported in written statements furnished to shareholders. The provision applies to capital gain dividends, exempt-interest dividends, foreign tax credits, qualified dividend income, dividends eligible for the corporate dividends received deduction, interest-related dividends and short-term gain dividends. d The Congressional Committee Report accompanying the Act (the Committee Report ) provides that a written statement furnishing the information may be a Form The Act also changes the rules that apply in a situation where a RIC reports capital gain dividends that exceed the amount of net capital gain that the RIC can pass through to its shareholders. Under prior law, excess designations of capital gain dividends were proportionately reduced to the correct amount. Under the Act, if a RIC has a taxable year other than the calendar year, any excess reported amounts of capital gain dividends are generally applied to reduce capital gain dividends after December 31. Similar rules will apply to exempt-interest dividends, interest-related dividends and short-term gain dividends. The above changes apply to taxable years beginning after the Date of Enactment. Comments: A RIC must determine the amount of its income and gains on the basis of its taxable year to determine the amount of distributions that must be made with respect to its taxable year. The amounts shown on a RIC s tax return are also determined with respect to the RIC s taxable year. In contrast, amounts reported on Form 1099s are determined on a calendar basis. Although the ability to report on 1099s is important, there may be some situations where there may still be a benefit to including a report on the amount of various items in an annual report. As an example, it may be useful to report amounts eligible for the corporate dividends received deduction since corporate shareholders do not normally get Form 1099s. Reports on the amount of short-term gain dividends and interest-related dividends may also be appropriate since foreign investors would not normally receive a Form The effect of any state law requirements should also be considered. It also seems that it should be appropriate to report the character of distributions on confirmations or account statements sent to shareholders. 22 Joint Committee on Taxation, Technical of H.R. 4337, the Regulated Investment Company Modernization Act of 2010, for Consideration on the Floor of the House of Representatives, (JCX-49-10), September 28, January 2011 / Issue 1 9

10 Modification of Rules for Allocating Earnings and Profits The Act modifies the rules for allocating earnings and profits (and return of capital distributions) among distributions made by RICs with a taxable year other than the calendar year to require that earnings and profits be allocated first to distributions on or before December 31 of the taxable year. Distributions made by RICs (and other corporations) are generally treated as dividends to the extent of current and accumulated earnings and profits. 23 Distributions in excess of earnings and profits are generally treated as return of capital distributions that are not taxed and that instead reduce a shareholder s tax basis in their stock. 24 Treasury Regulation Section (b) provides for a proration of current earnings and profits among current year distributions. Under the Act, if a RIC has a taxable year other than the calendar year, the current earnings and profits for such year will be allocated first to distributions on or before December 31 of the taxable year. The provision applies to distributions made in taxable years beginning after the Date of Enactment. Comments: This provision also has the effect of potentially pushing any return of capital distributions into the second part of the taxable year (i.e., after December 31 in the case of a RIC with a taxable year other than the calendar year). The provision is intended to reduce the possibility that amounts reported as dividends to shareholders on Form 1099s will be retroactively treated as return of capital distributions, as a result of transactions and activities after December 31. If a RIC has more than one class of stock, the provision in the Act applies separately to each class. The Committee Report related to the Act refers to Rev. Rul , 25 (earnings and profits first allocated to distributions on preferred stock prior to allocation 23 Section Section 301(c). d with respect to common stock distributions). The IRS has generally viewed multiple class RICs, where distributions vary as a result of 12b-1 fees and class expenses, as not having multiple classes for other purposes of the Code. Modification of Rules for Spillover Dividends The Act modifies the time for declaring a spillover dividend to provide that the dividend must be declared by the later of the 15th day of the ninth month following the close of the taxable year (to which the spillover dividend applies) or the extended due date for filing the tax return for such year. The Act also changes the timing requirement for payments of spillover dividends. The changes to the spillover dividend rules apply to distributions in taxable years beginning after the Date of Enactment. A RIC can elect to treat as paid during a taxable year certain dividends actually paid by the RIC in the subsequent year. 26 Such dividends are commonly referred to as spillover dividends. The spillover dividend election only affects the tax treatment of the RIC. The shareholders generally are taxed on dividends in the year of actual distribution of such dividends. Prior to the Act, a RIC electing to relate a spillover dividend back to a prior taxable year had to declare the spillover dividend no later than the time prescribed for filing the RIC s tax return for such prior taxable year (including the period of any extension of time granted for filing such return). 27 Although the due date for a RIC (or other corporate) tax return is normally the 15th day of the third month following the close of the year, 28 (e.g., March 15th for a calendar year) an automatic extension of six months for filing the return can be obtained if Form 7004 is filed prior to the original due date of the tax return. Because RICs normally file for the automatic six-month extension for filing the tax return, RICs can normally declare spillover dividends within 9½ months after the taxable year. 26 Section Section 855(a)(1). 28 Section 6072(b) C.B. 46. January 2011 / Issue 1 10

11 Prior to the Act, because the date for a RIC declaring spillover dividends depended on whether there was an extension to file the RIC s tax return, a failure to file an extension in a timely manner could have resulted in a RIC not being able to utilize the spillover dividend procedure. The Act modifies the time for declaring a spillover dividend to provide that the dividend must be declared by the later of the 15th day of the ninth month following the close of the taxable year or the extended due date for filing the tax return. Comments: As a result of the provision in the Act, a RIC will be able to declare spillover dividends within 9½ months after the end of the RIC s taxable year to which the spillover dividend relates, even if the RIC fails to file for an extension of its tax return. Prior to the Act, spillover dividends needed to be distributed within the 12-month period following the close of the taxable year to which the spillover dividend related and not later than the date of the first regular dividend payment made after the declaration of the spillover dividend. This rule caused additional complexity in planning the timing of spillover dividends. The Act retains the 12-month limit and changes the timing of the distribution requirement to provide that the distribution of a spillover dividend must be made not later than the date of the first dividend payment of the same type of dividend (for example, an ordinary dividend or a capital gain dividend) made after the declaration. For this purpose, a dividend attributable to short-term capital gains 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 payable from long-term capital gains. 29 The changes to the spillover dividend rules apply to distributions in taxable years beginning after the Date of Enactment. Pass-Through of Exempt-Interest Dividends and Foreign Tax Credits in Fund of Funds Structures The Act allows a qualified fund of funds (i) to pay exempt-interest dividends to its shareholders from exempt-interest dividends received from underlying funds and (ii) to elect to pass through the ability to take foreign tax credits (or deductions) to the extent that foreign taxes are passed through from underlying funds. A qualified fund of funds is a RIC that has at least 50% of the value of its total interests invested in other RICs at the end of each quarter of the taxable year. This provision is effective for taxable years beginning after the Date of Enactment. A RIC is able to pay exempt-interest dividends if, at the end of each quarter of the RIC s taxable year, at least 50% of the value of the RIC s total assets consists of obligations exempt from tax under Section Prior to the Act, if a RIC structured as a fund of funds invested in an underlying RIC that paid exempt-interest dividends, the fund of funds would not be able to itself pay exempt-interest dividends unless the fund of funds itself had at least 50% of its assets invested directly in tax exempt obligations at the end of each quarter. For this purpose, the shares in the underlying RIC paying exempt-interest dividends would have not been treated as tax exempt obligations even if all of such underlying RIC s assets were invested in tax exempt obligations. A RIC is also able to pass through to its shareholders the ability, subject to certain limitations, to take a credit (or deduction) for foreign taxes paid by the RIC if more than 50% of the RIC s assets at the close of the RIC s taxable year consist of stock or securities of foreign corporations. 31 Prior to the Act, if a RIC structured as a fund of funds invested in an underlying fund that passed through the ability to take the foreign tax credit, the fund of funds was not able to pass through the foreign tax credit to its shareholders unless the fund of funds otherwise directly invested more than 50% of its assets in the stock or securities of foreign corporations. A provision in the Act allows a qualified fund of funds (i) to pay exempt-interest dividends to its shareholders from exempt-interest dividends received from underlying funds and (ii) to elect to pass through the ability to take foreign tax credits (or deductions) to the extent that foreign taxes are passed through from underlying funds. A qualified fund of funds is a RIC that has at least 50% of the value of its total interests invested in other RICs at the end of each quarter of the taxable year. This provision is effective for taxable years beginning after the Date of Enactment. 29 Section 19 of the 1940 Act has rules requiring notices to shareholders identifying the source of distributions from sources other than net income. 30 Section 852(b)(5). 31 Section 853. January 2011 / Issue 1 11

12 Comments: If a fund of funds pays exempt-interest dividends to its shareholders, the fund of funds will not be able to deduct a portion of its expenses pursuant to Section 265(a)(3). The provision in the Act may potentially encourage the formation of funds of funds that invest in underlying municipal bond funds or in funds that pass through the foreign tax credit. It should be noted, however, that redemptions by a fund of funds of shares in underlying funds could result in net taxable gains that would have to be distributed to the shareholders of the fund of funds in order to avoid tax at the fund of funds level. Further, to the extent that such net gains are short-term capital gains, such distributions would normally be taxed as ordinary income to shareholders of the fund of funds. Clarification of the Treatment of Redemptions of Shares in Publicly Offered Open-End RICs The Act clarifies that a redemption of stock in a publicly traded open-end RIC is treated as a sale of stock. Prior to the Act, if a shareholder redeemed stock in a RIC, the rules in Section 302 generally determined whether the redemption payment would be viewed as payment in exchange for the stock, that would generally result in a capital gain or loss, depending upon the stockholder s basis in the stock, or whether the redemption payment would be treated as a distribution to which Sections 301 and 316 apply. 32 Distributions under Sections 301 and 316 are either treated as dividends or return of capital distributions or as gains from the sale of the stock, depending upon the amount of the RIC s current and accumulated earnings and profits. Under the rules in Section 302, a redemption by a shareholder of all of its shares in a RIC would be treated as a sale of the shares. 33 In determining whether all of the shareholder s shares have been redeemed, certain constructive ownership rules in Section 318 apply, attributing to the shareholder 32 See Rev. Rul , C.B Section 302(b)(3). ownership of shares owned by certain relatives, partnerships, and controlled corporations. 34 Under Section 302, a partial redemption of shares held in a RIC will be treated as a sale of the shares, and not as a dividend, if the redemption is substantially disproportionate, 35 or if the redemption is not essentially equivalent to a dividend. 36 Generally, a redemption will be substantially disproportionate if the shareholder s percentage of ownership in the RIC is reduced by more than 20%. 37 In other cases, the shareholder could argue that the redemption is not essentially equivalent to a dividend, particularly in situations where the shareholder has an insignificant ownership interest in the RIC. 38 Although RICs have normally treated redemptions of their shares as sales (and not as distributions potentially treated as dividends), the application of the rules in Section 302 may not have been certain in particular cases because a RIC may not have full information regarding the percentage ownership of its shareholders, particularly if shares are held through brokers or other nominees. Also, in some cases the application of the not essentially equivalent to a dividend test may not have been certain. The Act provides that, except to the extent provided in regulations, the redemption of stock of a publicly offered RIC is treated as a sale or exchange if the redemption is upon the demand of the shareholder and RIC issues only stock which is redeemable upon the demand of the shareholder (i.e., an open-end fund). For this purpose, a publicly offered RIC is a RIC whose shares are: continuously offered pursuant to a public offering (within the meaning of Section 4 of the Securities Act of 1933); regularly traded on an established securities market; or 34 Section 302(c). 35 Section 302(b)(2). 36 Section 302(b)(1). 37 See Section 302(b)(2). 38 See Rev. Rul , C.B. 92; Rev. Rul , C.B. 81. January 2011 / Issue 1 12