IRS Extends Guidance on Stock Distributions to Publicly-Traded SUMMARY On January 7, 2009, the Internal Revenue Service issued Revenue Procedure 2009-15 which extends to publicly-traded regulated investment companies ( RICs ) the temporary guidance in Revenue Procedure 2008-68 issued for real estate investment trusts ( REITs ) regarding the treatment of distributions consisting of part cash and part stock. Revenue Procedure 2009-15 provides that certain stock distributions made by RICs will be treated as taxable distributions for the purpose of determining both (1) the treatment of a RIC s shareholders and (2) the dividends-paid deduction of the RIC and whether it meets the distribution requirement for RIC qualification. 1 This rule is intended to permit publicly-traded RICs to limit cash distributions in order to maintain liquidity during the current financial situation. The rule does not apply to open-end RICs, shares in which are not publicly traded. Specifically, distributions of stock made by a RIC will be treated as distributions under Section 301 of the Internal Revenue Code (the Code ) if, among other requirements, (1) the RIC is publicly-traded on an established securities market in the United States; (2) the distribution is declared with respect to a taxable year ending before January 1, 2010; (3) the distribution permits shareholders to elect the receipt of either cash or stock subject to a cap (the Cash Limitation ) that limits the total amount of cash equal to ten percent or more of the declared distribution; and (4) the amount of stock that is distributed to a shareholder that receives stock in lieu of cash must be determined using a formula that equates the value of the stock received with the amount of cash that would otherwise be payable. If the Cash Limitation prevents a shareholder that elects a cash distribution from receiving the entire distribution in cash, the amount of cash must be prorated among electing shareholders so that no electing shareholder receives less than ten percent of that shareholder s total entitlement. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
BACKGROUND Under Section 852(a)(1) of the Code, a RIC must generally distribute at least 90% of its investment company taxable income to shareholders. A RIC that fails to meet this requirement will not be entitled to a dividends-paid deduction and thus may become subject to entity-level taxation. In the current economic environment, however, many RICs are experiencing cash-flow challenges and may seek to fulfill the distribution requirement with a distribution that in part consists of stock, rather than a distribution made entirely in cash. Although under Section 305(a) of the Code, gross income of a shareholder does not generally include distributions of stock made by a corporation to its shareholders, an exception in Section 305(b)(1) of the Code treats a distribution, made in stock, as taxable if the distribution may at the election of any shareholder be paid in stock or cash. 2 Under applicable Treasury Regulations, 3 if any shareholder may elect whether a distribution is made in cash or, alternatively, in stock or other securities of the corporation, that distribution is treated as a taxable distribution of property and a dividend to the extent paid out of the earnings and profits of the corporation. 4 THE REVENUE PROCEDURE Revenue Procedure 2009-15 provides that the Internal Revenue Service will treat stock distributions made by RICs as distributions to which Section 301 of the Code applies because of Section 305(b), provided that certain requirements are met. It is effective with respect to dividends made in respect of a taxable year ending on or before December 31, 2009 which are declared on or after January 1, 2008. To qualify under the Revenue Procedure: The distribution must be made by a RIC to its shareholders and with respect to its stock; Stock of the RIC paying the distribution must be publicly traded on an established securities market in the U.S.; The distribution must be declared on or after January 1, 2008 with respect to a taxable year that ends before January 1, 2010; Subject to the Cash Limitation, each shareholder must be entitled to receive its entire distribution in either cash or stock; The Cash Limitation may not limit the total amount of cash that may be paid to less than ten percent of the aggregate, declared distribution; If the aggregate cash amount is oversubscribed (i.e., limited by the Cash Limitation), each shareholder must receive a pro rata amount of cash that corresponds to its relative entitlement and is at least ten percent of its total entitlement; The number of shares that are received by any shareholder receiving property must be determined, as close as practicable to the payment date, 5 using a formula that equates the market value of the shares distributed with the cash that would otherwise be paid; and In the event an automatic dividend reinvestment plan (a DRIP ) is in effect with respect to a shareholder, the DRIP must apply only to the extent that, without the DRIP being in effect, that shareholder would have received a cash distribution. 6-2-
Revenue Procedure 2009-15 supersedes and amplifies Revenue Procedure 2008-68 to apply the same treatment of stock distributions to both RICS and REITs. * * * Copyright Sullivan & Cromwell LLP 2009-3-
ENDNOTES 1 2 3 4 5 6 In general, under Section 852(a) of the Code, the application of Subchapter M to a RIC requires that it distribute at least 90% of its investment company taxable income to shareholders and under Section 852(b) a deduction is allowed for dividends paid to shareholders. Moreover, Section 305(b)(2) provides that Section 305(a) does not apply to distributions that result in the receipt of property by some shareholders and cause the proportionate interests of other shareholders in the corporation s earnings and profits to increase. Treas. Reg. 1.305-2. Code 316(a). Rev. Proc. 2009-15, 3(5). Under a DRIP, shareholders typically receive a small discount on shares acquired pursuant to the DRIP relative to the market price. -4-
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