Cash Settlement and Note from Investment Adviser Are Qualifying RIC Income

By Alan Munro, CPA, Washington, DC

Editor: David J. Kautter, CPA Ernst & Young LLP

In Letter Ruling 200739010, the Service ruled that a regulated investment company’s (RIC’s) receipt of cash and a note from its investment adviser (IA) are qualifying income under Sec. 851(b)(2). Further, although the note caused a Sec. 851(b)(3) asset-test failure, the IRS ruled that satisfaction of the note within 30 days of the close of the quarter cured the failure.

Facts

A RIC invested in a passive foreign investment company (PFIC), which invested in segregated portfolio companies (SPCs) taxable as partnerships. The SPCs held deposits as collateral for the PFIC’s trading activities with a company that operated as a private bank. At a certain point, the IA to the PFIC and the SPCs requested a return of its invested money from this private bank. After the money was transferred, the bank’s parent company froze all customer accounts, preventing any persons from receiving invested money; the bank and its parent corporation filed voluntary bankruptcy petitions.

The RIC made two tenders to the PFIC for redemption of its PFIC shares. Subsequently, the RIC determined that, as a result of the bankruptcy, its PFIC shares had depreciated between 8% and 30% of the tender fair market value; in addition, the PFIC’s adviser indicated that the shares were not transferable.

Ultimately, to maintain goodwill and its reputation, the IA paid the RIC an amount equal to the amount that would have been paid on the two earlier tenders. The IA transferred cash and a note to the RIC as settlement of its interests in the PFIC and the RIC agreed to give the IA any amounts it received from the PFIC.

The IA satisfied the note and the RIC liquidated the next day by distributing its PFIC shares to a liquidating trust. The RIC represented that the transactions were not entered into to artificially inflate its qualifying income and that, at the close of its quarter, the RIC otherwise satisfied the diversification test of Sec. 851(b)(3) if the value of the note was treated as cash held by the RIC.

Analysis

Generally, to qualify as a RIC, at least 90% of its gross income must be from certain sources, including dividends; interest; gain from the sale or other disposition of stock, securities, or foreign currencies; or other income derived from its business of investing in such stock, securities, or currencies.

Rev. Rul. 92-56 examined the issue of qualifying income of a RIC. It held that if, in the normal course of its business, a RIC received a reimbursement from its investment adviser and the reimbursement was includible in the RIC’s gross income, the reimbursement was qualifying income under Sec. 851(b)(2).

The Service found that in this case, the receipt was income to the RIC. Because the RIC received the cash payment and note from its investment adviser under a settlement agreement in the normal course of its business of investing in stock, securities, or foreign currencies, the receipt of the note and the cash payment by the RIC were qualifying income under Sec. 851(b)(2).

The Sec. 851(b)(3) diversification requirements prevent RICs from concentrating their investment assets in a small number of companies or in certain types of assets. Under Sec. 851(d), a corporation that meets these diversification requirements at the close of any quarter will not lose its status as a RIC because of a discrepancy in a subsequent quarter between the value of its various investments and such requirements, unless the discrepancy exists immediately after the acquisition of any security (or other property) and is wholly or partly the result of this acquisition. A corporation that does not meet such requirements at the close of any quarter, by reason of a discrepancy existing immediately after the acquisition of any security (or other property), shall not lose its RIC status during such quarter if the discrepancy is eliminated within 30 days after the close of that quarter.

In this case, the RIC’s assets did not meet the diversification requirement test of Sec. 851(b)(3) at the close of the quarter. However, by disposing of the note for cash within 30 days of the close of the quarter, the RIC eliminated any discrepancy. Therefore, if the RIC otherwise satisfied the requirements of Sec. 851(b)(3), it will be considered to have met these requirements at the close of the quarter.

Implications

Rev. Rul. 92-56 left some doubt about whether this type of reimbursement was gross income. This letter ruling clearly states the Service’s position that it is income. Given that conclusion, it is not surprising that the Service ruled that the income qualified under the “other income” provision of Sec. 851(b)(2). It is worth noting that the Service treated the payoff of the note within the 30-day cure period as a disposition and that the RIC carefully liquidated the day after that payoff to avoid raising the diversification issue a second time (because the liquidation date is a testing date as well).


Editor Notes:

David J. Kautter, CPA Ernst & Young LLP Washington, DC

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

If you would like additional information about these items, contact Mr. Kautter at (202) 327-8878 or david.kautter@ey.com.

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