On September 27, the Internal Revenue Service (IRS) and the Department of the Treasury (Treasury) issued proposed regulations (REG-123600-16) (the Proposed Regulations) under section 851 addressing the income test applicable to regulated investment companies (RICs) that hold interests in certain foreign corporations. The IRS simultaneously issued a new revenue procedure (Rev. Proc. 2016-50) (the Revenue Procedure) in which it stated that it will no longer issue rulings on whether a financial instrument constitutes a security for certain purposes applicable to RICs. While the Proposed Regulations and the Revenue Procedure arose in connection with the ongoing debate surrounding RIC investments in commodity derivatives, commodity-linked notes, and controlled foreign corporations (CFCs) that invest in commodities, the Proposed Regulations (if finalized in their current form) will have a significant impact on all RICs (including business development companies (BDCs)) that hold investments in the securities of CFCs or passive foreign investment companies (PFICs).
As discussed in more detail below, the Proposed Regulations generally provide that income required to be included (a Required Income Inclusion) in the income of a RIC from a CFC under section 951(a)(1)(A)(i) of the Internal Revenue Code (the Code) or from a PFIC under section 1293(a) of the Code will not be considered qualifying income for purposes of section 851(b)(2) of the Code unless the CFC or PFIC distributes such income in the current taxable year. This position represents a reversal of the IRS's historical ruling position and will require RICs to carefully monitor their investments in CFCs and PFICs to ensure that any Required Income Inclusion is timely distributed in order to constitute qualifying income.
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For much of the last decade, the IRS has lurched back and forth in trying to determine the limits placed upon RICs that seek exposure to commodities as part of their investment objectives. The principal issue that the IRS has wrestled with is to what extent derivative investments in commodities would satisfy the source-of-income and asset-diversification requirements applicable to RICs under section 851(b) of the Code. To qualify as a RIC, a corporation must, among other things, derive at least 90% of its gross income for each taxable year from specific sources, including dividends, interest, gains from the sale or other disposition of stocks and securities, and other income derived from a RIC&rsquo;s business of investing in stock, securities or currencies (the 90% Gross Income Test). In addition, the RIC must satisfy at the end of each quarter of the taxable year two asset-diversification tests (the Asset-Diversification Tests). In particular, as relevant here, at the end of each quarter, at least 50% of a RIC's total assets must be invested in cash and certain other qualifying securities (the 50% Diversification Test). For purposes of these tests, the Code provides that the term 'securities' has the same meaning as provided in the Investment Company Act of 1940 (the 1940 Act). The Proposed Regulations and the Revenue Procedure are intended to bring closure to the IRS's guidance regarding what derivative investments in commodities would constitute 'securities' that would produce qualifying income for purposes of the 90% Gross Income Test and would be good assets for purposes of the 50% Diversification Test.
To understand the potential impact of these new rules, this Legal Alert discusses the IRS's historical guidance related to investments in commodity derivatives by RICs and the Proposed Regulations and the Revenue Procedure and their impact on RICs. While these new rules are a result of the IRS&rsquo;s guidance involving RICs seeking to gain exposure to commodities, it is important to understand that the impact of these new rules is not limited to commodity investments.
IRS Historical Guidance Involving Investments in Commodity Derivatives by RICs.There is little doubt that direct investments in commodities are not securities within the meaning of the 1940 Act. As a result, it is clear that the 90% Gross Income Test and the 50% Diversification Test substantially limit the ability of RICs to make direct investments in commodities (other than in connection with certain hedging transactions). What is less certain is the extent to which investments in commodity derivatives would be considered securities. At the beginning of 2006, the IRS sought to clarify this issue by issuing Rev. Rul. 2006-1. In that ruling, the IRS declared that derivative investments in commodities &ndash; in this case, futures on commodity indexes &ndash; were not securities within the meaning of section 2(a)(36) of the 1940 Act. As a result, such investments would not produce qualifying income for purposes of the 90% Gross Income Test and would not be good assets for purposes of the 50% Diversification Test.
Because there were a number of mutual funds in existence at the time that were investing in commodities, the ruling created a significant backlash from the mutual fund industry. This industry backlash caused the IRS to modify and clarify its original ruling. In Rev. Rul. 2006-31, the IRS clarified that its ruling was not intended to apply to all instruments (such as structured notes) that provided exposure to commodities. As a result, mutual funds were able to continue to offer commodity funds, provided that they utilized structured notes or other structured investments, but they could not invest directly in futures or forward contracts on commodities.
Beginning in 2006, the IRS also issued a series of private rulings (70+) relating to what constituted qualifying income for RICs seeking exposure to commodities. In addition to ruling that income from certain structured notes would constitute qualifying income for purposes of the 90% Gross Income Test, the IRS ruled in most of these rulings that income derived from an investment in a 100% owned foreign subsidiary that invests in commodity derivatives, including forward and future contracts on commodities, also would be qualifying income. In this respect, if a RIC owns at least 10% of the stock of a foreign corporation and more than 50% of the total voting power in such foreign corporation is owned by U.S. shareholders, the foreign corporation is considered a CFC and the RIC would be required to include its allocable share of the Required Income Inclusion from the CFC in its income each year, regardless of whether the CFC made any distributions. (A similar income inclusion is required where a RIC invests in a foreign corporation that is considered a PFIC, and the RIC makes a qualified electing fund election with respect to such PFIC.) Section 851 of the Code (in the flush language) provides that a Required Income Inclusion from a CFC (or a PFIC) will constitute dividend income for purposes of the 90% Gross Income Test provided that such amounts were distributed by the CFC (or PFIC) to the RIC in the current taxable year. The Code does not provide specific guidance on the treatment of the Required Income Inclusion from a CFC (or PFIC) for purposes of the 90% Gross Income Test where such income is not distributed in the current year. In these rulings, the IRS ruled that the Required Income Inclusion from a CFC (or PFIC) would constitute qualifying income for purposes of the 90% Gross Income Test even if not distributed in the current year. In so ruling, the IRS presumably concluded that such income would constitute 'other income' from the RIC's business of investing in securities.
Certain members of Congress objected to these rulings and did not believe that RICs should be investing in commodities. In addition, an earlier version of the Regulated Investment Company Modernization Act of 2010 would have explicitly permitted RICs to invest in commodities, but this provision was eliminated from the final version of the act, which suggested that Congress did not approve of RICs investing in commodities. In response to these and other factors, the IRS announced in 2011 that it was temporarily suspending further issuances of new rulings in this area. This informal suspension on new rulings has remained in place throughout the last five years
The Proposed Regulations. The Proposed Regulations provide that Required Income Inclusions from CFCs (and PFICs) will be treated as dividends for purposes of the 90% Gross Income Test only if actual distributions attributable to those inclusions are made by the CFCs (or PFICs) during the current year. They further provide that such inclusions will not constitute 'other income' from a RIC's business of investing in securities. As a result, under the Proposed Regulations, it would appear that the Required Income Inclusions from a CFC (or PFIC) will only be qualifying income for purposes of the 90% Gross Income Test if such income is distributed by the CFC (or PFIC) in the current year. This represents a reversal of the IRS&rsquo;s position set forth in the series of private rulings discussed above.
Sutherland Observation: The Proposed Regulations do not prohibit RICs from investing in commodities through CFCs. However, if the Proposed Regulations are finalized in substantively the same form, RICs may need to alter their current operating procedures to ensure that their CFCs make timely distributions each year of the Required Income Inclusion.
It should be noted that the Proposed Regulations are not limited to CFCs (or PFICs) that invest in commodities. Consequently, if the regulations are finalized in their current form, RICs (including BDCs) holding interests in CFCs (or PFICs), including CFCs (or PFICs) engaged in activities unrelated to investing in commodities, may need to ensure that any Required Income Inclusions from such CFCs (or PFICs) are distributed currently to ensure satisfaction of the 90% Gross Income Test. RICs also will need to pay attention to the allocation rules in Treas. Reg. &sect; 1.959-3 to make sure that any distributions made are allocated to the earnings and profits giving rise to the Required Income Inclusions. Other general tax principles, such as certain substance-over-form principles, also must be considered in determining whether a RIC has received the appropriate distribution from a CFC (or PFIC)
Sutherland Observation: If a RIC holds a non-controlling interest in a CFC or a PFIC, the RIC may not be in a position to cause such entity to make timely distributions of the Required Income Inclusion. As a result, RICs may have to carefully structure investments in such entities to ensure that the required distributions will be timely made or may need to limit their investment in such entities where the required distributions will not or may not be timely made.
The Proposed Regulations have a proposed effective date of 90 days after they are issued in final form.
Revenue Procedure 2016-50. As discussed above, the term 'security' as used in section 851(b) has the same meaning as provided in section 2(a)(36) of the 1940 Act. In the preamble to the Proposed Regulations, the IRS and Treasury explained that they had determined that the IRS should not issue further guidance on what constitutes a security for purposes of section 851(b) of the Code because they concluded that it should be sole province of the Securities and Exchange Commission (SEC) to interpret the definition of 'security' in the 1940 Act. As a result, simultaneously with the issuance of the Proposed Regulations, the IRS issued the Revenue Procedure, which adds determinations of whether an instrument is a security under the 1940 Act for purposes of section 851 of the Code to the no-rule list provided in Rev. Proc. 2016-3. Accordingly, going forward, the IRS will not ordinarily issue rulings on what constitutes a security under the 1940 Act for purposes of section 851 of the Code. The IRS and Treasury Department have asked for guidance on whether its prior rulings in this area, including Rev. Rul. 2006-1 and Rev. Rul. 2006-31, should be withdrawn.
Sutherland Observation: Although the IRS indicated that interpretations of the definition of a security under the 1940 Act should be the sole province of the SEC, it is unclear whether the SEC will provide any guidance to RICs on this issue where it is relevant for U.S. federal tax purposes but not U.S. federal securities law purposes. As a result, RICs may face uncertainty on whether their financial instruments will be treated as securities within the meaning of the 1940 Act for purposes of section 851 of the Code.