Editor: Anthony S. Bakale, CPA
Earlier this year, Treasury and the IRS issued final regulations (T.D. 9851) related to regulated investment company (RIC) qualification testing for RICs invested in foreign corporations treated for U.S. federal income tax purposes as controlled foreign corporations (CFCs) or passive foreign investment companies (PFICs). The final regulations are an about-face from the original IRS position in the proposed regulations released in September 2016 (REG-123600-16) and represent a win for the mutual fund industry. The final rule, effective March 19, 2019, and applicable to tax years that begin after June 17, 2019, allows a RIC invested in CFCs and PFICs to treat the required CFC inclusion or PFIC inclusion (for qualified electing funds, or QEFs), respectively, as qualifying income for purposes of a RIC's qualifying income test.
RICs are typically structured as corporations for tax purposes. To avoid two tiers of tax, Congress exempts a RIC from federal income tax as long as the RIC meets quarterly diversification requirements and an annual gross income requirement and distributes substantially all of its taxable income and net capital gain to shareholders. While a RIC could be any corporation, most RICs are mutual funds, closed-end funds, or exchange-traded funds. Shareholders of RICs are taxed on the distributions received from the RIC; the taxability of the distributions is reported on Form 1099-DIV, Dividends and Distributions.
RIC investments in CFCs and PFICs
For U.S. tax purposes, a CFC is defined as a foreign corporation where more than 50% of the total value or the total combined voting power of all classes of stock of the corporation is owned by U.S. shareholders, including RICs, during any day of the foreign corporation's tax year. A RIC will commonly own a CFC to gain exposure to investments that may not ordinarily meet a RIC's income and diversification requirements if held directly by a RIC.
A RIC is allowed to invest up to 25% of its total assets in any one corporation, including a CFC, and is limited to investing up to 25% of its total assets in corporations it controls. U.S. shareholders of CFCs are required to include their pro rata share of taxable income from the CFC, known as a Subpart F inclusion, in their gross income on the last day of the CFC's tax year.
A PFIC is a foreign corporation where at least 75% of the corporation's gross income is from passive sources or at least 50% of the corporation's assets produce passive income. Typically, a RIC will make a mark-to-market election with respect to its investments in a PFIC. Alternatively, a RIC is also allowed to make a QEF election. In the latter case, the RIC includes in its taxable income its pro rata share of ordinary income and net capital gain from the PFIC. A RIC is subject to the same limitation of 25% of its total assets with respect to investments in PFICs.
How the 2016 proposed regulations addressed gross income testing
The new regulations relate to the requirement that at least 90% of the RIC's gross income is derived from dividends; interest; payments with respect to securities loans; gains from the sale or other disposition of stock, securities, or foreign currencies; or other income. Prior to 2016, most RICs with a CFC subsidiary treated Subpart F income from the CFC as "other income" to satisfy this rule. The same was true for the RIC's portion of ordinary income or capital gains from a PFIC making a QEF election.
Then came proposed regulations issued in late 2016, which required the CFC (or PFIC) to make a distribution to the RIC in the amount of the Subpart F inclusion (or QEF inclusion) for that amount to constitute "other income" for this purpose. If a distribution was not made, the proposed regulations treated the required inclusion as non-qualifying income to the RIC, which if greater than 10% of a RIC's gross income (combined with other non-qualifying income) would cause a failure in the RIC's qualification tests and subject the RIC to tax on the amount of the failure.
The new and final rule for RICs invested in CFCs and PFICs regarding the qualifying-income test
Treasury and the IRS received several comments on the proposed regulations. All of them recommended that they reconsider the requirement that a distribution be made from the CFC (or PFIC) to the RIC for the required inclusion to qualify as "other income" for purposes of the 90% test. The commentators noted that requiring a cash distribution could create unintended consequences for the RIC, especially a RIC that did not have full control of the timing of any distributions made from the CFC (or PFIC).
As a result, Treasury and the IRS issued final regulations providing that as long as the required inclusion is derived with respect to the RIC's business of investing in stocks, securities, or currencies, the amount will be treated as "other income" and, thus, would be qualifying income for purposes of the RIC's 90% gross income requirement. A RIC investing in CFCs (or PFICs) will no longer need to plan for distributions from the CFC (or PFIC) to be assured the required inclusions will be treated as qualifying income to the RIC.
Additional IRS comments on qualification for RICs with derivative contracts
Treasury and the IRS also received comments on the IRS's process for issuing a ruling on whether a financial instrument or position meets the definition of a security under the Investment Company Act of 1940. The IRS stopped issuing these rulings to RICs in 2016, ending the practice of providing certainty to a RIC on whether a particular financial instrument or position would be treated as a security (and thus income from the security is qualifying income to the RIC). The IRS affirmed in the preamble to the final regulations that it will continue the practice of not issuing rulings or determinations in this area.
Related to this, the IRS also received comments on two revenue rulings issued in 2006 on whether derivative contracts would be treated as securities (Rev. Ruls. 2006-1 and 2006-31). The rulings clarified that certain types of derivative contracts could meet the definition of a security for purposes of a RIC's qualification tests, while others may not. The IRS had considered withdrawing these rulings but decided not to withdraw them after comments it received suggested that doing so would create confusion and uncertainty with respect to investments in derivative contracts by a RIC.
While the new guidance has been received favorably by RIC managers, the calculation of investment company taxable income and net capital gain remains unchanged, so RIC shareholders likely will not see a difference in the amount of distributions received from a RIC or how they are reported on Form 1099-DIV. The guidance is less restrictive and provides certainty with respect to a RIC's qualifying-income requirement when a RIC manager uses CFCs, PFICs, and/or derivatives as part of the RIC's strategy.
Anthony Bakale, CPA, is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.