RIC controlled group regulations: Are you in compliance?

Transcription

1 RIC controlled group regulations: Are you in compliance? In September 2015, the IRS issued final regulations that clarified its position with respect to the 25% controlled group asset diversification test for regulated investment companies (RICs) as defined in Internal Revenue Code (IRC) Section 851 and Revenue Procedure (Rev. Proc.) , which provides safe harbors for fund-of-fund structures. 1,2 The final regulations are generally applied prospectively, whereas the Rev. Proc. is applied prospectively. This article discusses: (I) the background of the RIC asset diversification qualification requirements, (II) the impact of the final controlled group regulations on the RIC asset diversification requirements as clarified by the IRS, and (III) the safe harbor provisions under Rev. Proc Background of the RIC asset diversification qualification requirements Among the requirements to qualify as a RIC under Subchapter M, a fund must meet the quarterly asset diversification requirements under IRC Section 851, which include both the 50% test and 25% test as described below. Under the 50% test, at least 50% of a fund s total asset value must be represented by the following at the close of each quarter: Cash, cash items (including receivables), government securities, securities of other regulated investment companies, and Securities of any one issuer that are not greater than 5% of the value of total assets and no more than 10% of the outstanding voting securities of such issuer. 3 These items are commonly referred to as good assets. Under the 25% test, not more than 25% of the value of a fund s total assets may be invested in the following at the close of each quarter: The securities (other than government securities and RICs) of any one issuer, The securities (other than RICs) of two or more issuers, which: (a) the RIC controls, and (b) are engaged in the same or similar trades or businesses or related trades or businesses, or The securities of one or more qualified publicly traded partnerships (QPTPs). 4 The 50% test and the 25% test are significantly different. A RIC must have 50% of its assets represented by good assets under the 50% test, whereas, a RIC may not have more than 25% of the value of its total assets invested in certain securities. Thus, if total assets of a RIC were made up of 40% prepaid expenses and 60% invested in U.S. Treasury notes, the RIC would pass both the 50% test and 25% test. The RIC would have 60% of its total value represented by good assets meeting the 50% test (U.S. Treasury notes are good assets) and the RIC would meet the 25% test because prepaid expenses are not considered to be invested in securities. 1 IRS. Treasury Decision IRS I.R.B IRC Section 851(b)(3)(A). 4 IRC Section 851(b)(3)(B).

2 For the purposes of the 25% test, the term controls is defined as ownership in a corporation of 20% or more of the total combined voting power of all classes of stock entitled to vote. 5 IRC Section 851(c) also provides a look-through rule for the 25% test, which requires a RIC to aggregate its proper proportion of the securities held by a corporation that is a member of its controlled group with its direct holdings to the extent provided under regulations (the controlled group rules). 6 A controlled group is defined as one or more chains of corporations connected through stock ownership with the taxpayer if: (i) 20% or more of the total combined voting power of all classes of stock entitled to vote of each of the corporations (except the taxpayer) is owned directly by one or more of the other corporations; and (ii) the taxpayer owns directly 20% or more of the total combined voting power of all classes of stock entitled to vote, of at least one of the other corporations. 7 There are two components to the application of the controlled group rules for the purposes of the 25% test: (i) the aggregation of the controlled corporations that are engaged in the same, similar or related trades or businesses; and (ii) the look-through to the underlying securities of the controlled corporations that need to be aggregated with other direct holdings of the RIC. A fund-of-fund structure is composed of a RIC (an Upper-Tier RIC) that invests in stock of one or more other RICs (Lower-Tier RICs). The Upper-Tier RIC and the Lower-Tier RIC are usually members of the same fund family. 8 A fund-of-fund structure may be used by an Upper-Tier RIC to allocate its investment exposure among the investment exposures of one or more Lower-Tier RICs in which it invests. 9 IRC Section 851(d) provides for certain cures to a fund s failure of asset diversification under the 50% and 25% tests. First, the fair market value exception provides that a corporation, which meets the asset diversification requirements 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 such requirements unless such discrepancy: (i) exists immediately after the acquisition of any security or other property, and (ii) is wholly or partly the result of such acquisition. Second, the 30-day cure provision provides that a corporation, which does not meet the requirements at the close of any quarter by reason of a discrepancy existing immediately after the acquisition of any security or other property that is wholly or partly the result of such acquisition during such quarter, shall not lose its status for such quarter as a RIC if the discrepancy is eliminated within 30 days after the close of such quarter. In such cases it shall be considered to have met such requirements at the close of such quarter. Clarification of the controlled group rules Prior to issuing the final regulations, the IRS issued proposed regulations in The Treasury received a number of comments related to the proposed regulations many of which addressed concerns with the fund-offund structure. Following is a discussion of select issues in the final regulations. Definition of controlled group Prior to clarification by the IRS, taxpayers may have interpreted the application of the controlled group rules to require at least two 20% investments consisting of: (i) a direct investment by the RIC in a corporation (a direct investment), and (ii) the direct investment owning a controlled investment in another corporation. This approach was based upon an interpretation of IRC Section 851(c)(3) and examples provided in the prior regulations that do not conform with the interpretation of the IRS and Treasury based on the plain language in IRC Section 851(c) regarding the application of the controlled group rules. 10 Treasury Decision (TD) 9737 added language to Treas. Reg. Section and revised Treas. Reg. Section , with an additional example related to the controlled group rules. The clarifying language makes it clear that a single corporation, which controls another corporation, will create a controlled group. Thus, if a RIC owns a direct controlling investment in a corporation, any securities held by such controlled corporation will be attributed to the RIC to the extent of the proportionate ownership under the controlled group rules. 5 IRC Section 851(c)(2). 6 IRC Section 851(c)(1). 7 IRC Section 851(c)(3). 8 Rev. Proc Section Rev. Proc Section IRS TD 9737 preamble stating: These final regulations clarify, through revisions to the existing examples, that as few as two corporations are enough to constitute a controlled group [under Section 851(c)(3)]... The Treasury Department and the IRS believe that the interpretation of the controlled group rules reflected in these final regulations is consistent with both the statutory language of Section 851(c)(3) and the well-established interpretation of the analogous code provisions.

3 Qualified publicly traded partnerships In late 2004, Congress enacted rules that made it easier for RICs to invest in certain Master Limited Partnerships. The rules allow RICs to invest in qualified publicly traded partnerships (QPTPs) as defined in IRC Section 851(h) (QPTPs). However, a RIC is limited to an investment of not more than 25% of its total asset value in QPTPs in the aggregate. 11 QPTPs generate good income. 12 A significant driver for the final regulations appears to be the IRS s concern that RICs were gaining exposure to QPTPs in excess of 25% of the value of their total assets. A hypothetical example that could arise from a RIC investing in other RICs that hold QPTPs is illustrated in the following example: RIC A is a calendar-year taxpayer and has the following asset allocation as of Dec. 31, 2016: Various QPTPs 25% RIC B 15% RIC C 15% Other securities 45% Total assets 100% RIC A owns 25% of the voting stock in RIC B and RIC C, and both have maximized their investments in QPTPs for purposes of the 25% test. RIC A directly owns 25% in QPTPs, but it also indirectly owns 6.25% in QPTPs through its ownership of RIC B (25% x 25%) and its ownership of RIC C (25% x 25%) under the controlled group rules. Therefore, RIC A collectively owns investments in QPTPs (direct and indirect), totaling 37.5% of its gross total asset value for the purposes of the 25% test. 13 The final regulations also clarify that an aggregation of QPTPs is required for controlled groups. The rules apply to fund-of-funds structures and when the RIC invests in a C corporation that invests in QPTPs based on Example 7 of Regulation The chart below summarizes Example 7. In this example, Investment Company T does not meet the 25% test because its assets are as follows: Because Investment Company T owns more than 20% of the voting power of Corporation A, the allocable percentage of the securities held by Corporation A (specifically the QPTPs) needs to be attributed to Investment Company T. When this percentage (16%) is aggregated with the percentage of QPTPs owned directly by Investment Company T (15%), Investment Company T fails the 25% test. Percentage of total assets Cash and government securities 40% Securities of Corporation A (80% of its total assets are invested in QPTPs) Voting percentage 20% >20% Corporation A (80% x 20%) Percentage of QPTPs 16% Securities of various QPTPs (within the meaning of IRC Sections 851(b) (3) and 851(h)) 15% <10% QPTPs held directly 15% Securities of various corporations (not exceeding 5% of its assets in any one company) 25% <10% Total assets 100% Percentage of total assets invested in QPTPs 31% FAIL >25% 11 IRC Section 851(b)(3)(B)(iii). 12 IRC Section 851(b)(2)(B). 13 It should be noted that the actual QPTP exposure could have been even greater if the fair market exception with respect to the QPTP investments was utilized by any of the funds. However, this result is no longer possible under the final regulations unless Rev. Proc , discussed below, were to apply (i.e., the anti-abuse provision of the Rev. Proc. does not apply).

4 Other issues related to the controlled group rules issue The final regulations have potential tax implications well beyond limiting a RIC s QPTP exposure. For example, a RIC must consider how the controlled group rules affect RICs that hold blocker corporations, including cases where the controlled blocker corporation holds the equity of the underlying investment and the RIC owns the debt of the controlled corporation and/or the underlying investment of the controlled corporation. As discussed previously, there are two components to the controlled group rules the look-through rules and aggregation of controlled corporations that are in the same, similar or related trades or businesses. A RIC with a blocker corporation(s) will need to carefully navigate these components in order to determine the risks, if any, of failing the 25% test. In addition to the various tax considerations, there are a number of administrative considerations resulting from the final regulations. For example, in cases where there are chains of corporations, it may be difficult to determine the required information for the 25% test because the RIC may have a very small indirect holding in the underlying security. In addition, there may be additional administrative and practical considerations for fund-of-fund structures. For example, the underlying funds may have different quarter-ends or an underlying fund(s) may utilize the fair market value exception or the 30-day cure provision as provided under IRC Section 851(d). Effective dates The final regulations are effective Sept. 15, 2015, but are applicable to quarters that begin on or after Dec. 14, However, the final regulations are applicable to the fair market value exception at the close of all prior quarters for purposes of testing any quarter that begins after March 14, Thus, the regulations are retroactive for purposes of applying the fair market value exception under IRC Section 851(d)(1). Revenue Procedure The IRS issued Rev. Proc concurrently with the final regulations in order to address some of the concerns raised. As noted previously, if an Upper-Tier RIC holds stock of a Lower-Tier RIC and a controlled group exists, the Upper-Tier RIC must look through to the securities of the Lower-Tier RIC for purposes of the 25% test. However, Rev. Proc states that an Upper-Tier RIC does not need to look through to the securities of the Lower- Tier RIC if either of two safe harbors are met. An Upper- Tier RIC will be treated as satisfying the 25 percent test if either of the following safe harbor conditions are met: The Upper-Tier RIC invests solely in cash, cash items (including receivables), government securities, and securities of one or more Lower-Tier RICs and each Lower-Tier RIC that is a member of the Upper- Tier RIC s controlled group, taking into account the market value exception and 30-day cure provision of Section 851(d)(1), is treated as satisfying the 25% test for each quarter that ends concurrently with the quarter of the Upper-Tier RIC (Safe Harbor 1) 14 ; or The Upper-Tier RIC invests in cash, cash items (including receivables), Government securities, securities of one or more Lower-Tier RICs, and other stocks and securities, and: 14 Rev. Proc Section 4.01(1).

5 (a) Each Lower-Tier RIC that is a member of the Upper-Tier RIC s controlled group taking into account the market value exception and 30-day cure provision satisfies the 25% test for each quarter that ends during or concurrently with the quarter of the Upper-Tier RIC; and (b) Disregarding the Upper-Tier RIC s investments in the securities in each Lower-Tier RIC that is a member of the Upper-Tier RIC s controlled group and the Upper-Tier RIC s proportionate share of any securities held by those Lower-Tier RICs, the Upper- Tier RIC satisfies the 25% test with respect to the remainder of its assets (Safe Harbor 2). 15 In determining whether a RIC within a chain of corporations satisfies the safe harbor requirements, the 25% test taking into account the market fluctuation exception and 30-day cure provision is applied: (i) first, to a Lower-Tier RIC that is not also an Upper-Tier RIC in the chain; and (ii) next, successively up the chain to each other Lower-Tier RIC in the chain; and (iii) last, to the Upper-Tier RIC that is not also a Lower-Tier RIC. 16 The Rev. Proc. provides an anti-abuse provision that does not apply to an Upper-Tier RIC if a purpose of the fund-of-fund structure is to enable the Upper-Tier RIC to invest directly or indirectly in the securities of an issuer or a category of issuers at levels not permissible under the 25% test. 17 Although Rev. Proc may appear to be restrictive, the language mirrors that in the code. Unlike the 50% test, which is based upon asset value, the 25% test is based upon the investment in securities. Thus, certain assets, such as prepaid expenses, may create an issue with the 50% test but not the 25% test. In addition, the Rev. Proc. uses the term solely in Safe Harbor 1, whereas Safe Harbor 2 does not require that investments solely consist of the listed investments. As illustrated in Example 1 and Example 2, Safe Harbor 2 requires the Upper-Tier RIC to pass the 25% test independent of the controlled group securities. Example 1 Fund X has the following investments at the end of a given testing quarter, and each Lower-Tier RIC is a member of a controlled group with Fund X. Fund X s fund-of-funds structure does not have a purpose of enabling Fund X to invest (directly or indirectly through one or more members of Fund X s controlled group) in securities of an issuer or category of issuers at levels that would not be permissible if the 25% test were applied without regard to Rev. Proc % of assets Lower-tier RIC A 56.00% Lower-tier RIC B 43.75% Total RICs (controlled) 99.75% Security C 0.25% Total assets % Although Security C makes up a very small portion of the portfolio s total assets, it represents 100% of the security holdings under Section 4.01 of Rev. Proc Because Fund X s investment in each Lower- Tier RIC is disregarded, Fund X fails the 25% test under Rev. Proc Thus, although Fund X qualifies to utilize the Rev. Proc., relying on the safe harbor would result in the fund failing the 25% test. Accordingly, the fund would not want to rely on the Rev. Proc. and instead would need to apply the general look-through rules as reflected in the final regulations. 15 Rev. Proc Section 4.01 (2)(a) and (2)(b). 16 Rev. Proc Section Rev. Proc Section 3.02.

6 Example 2 Assume the same facts as in Example 1 except this time Lower-Tier RIC A is not a member of Fund X s controlled group (i.e., Fund X owns less than 20% of the vote). In this case, Fund X would pass the 25% test by disregarding its investment in Lower-Tier RIC B, assuming Lower-Tier RIC A is a qualified RIC inclusive of any corrective measures. Although Lower-Tier RIC A represents more than 25% of the total asset value, the code specifically excludes RICs that are not part of a controlled group from the application of the controlled group rules under the 25% test, and Security C represents less than 25% of the value of the adjusted total assets (assets other than Lower-Tier RIC B). Contacts Bob Dunne Partner, Corporate Tax T E bob.dunne@us.gt.com Heidi Ryan Patton Senior Manager, Corporate Tax T E heidi.patton@us.gt.com Maureen Gordon Manager, Corporate Tax T E maureen.gordon@us.gt.com grantthornton.com/tax Rev. Proc is effective for quarters ending after Sept. 14, Tax professional standards statement This content supports Grant Thornton LLP s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Connect with us linkd.in/grantthorntonus Grant Thornton refers to Grant Thornton LLP, the U.S. member firm of Grant Thornton International Ltd (GTIL), and/or refers to the brand under which the GTIL member firms provide audit, tax and advisory services to their clients, as the context requires. GTIL and each of its member firms are separate legal entities and are not a worldwide partnership. GTIL does not provide services to clients. Services are delivered by the member firms in their respective countries. GTIL and its member firms are not agents of, and do not obligate, one another and are not liable for one another s acts or omissions. In the United States, visit grantthornton.com for details Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd