On March 18, 2019, the U.S. Department of the Treasury and the Internal Revenue Service issued final tax regulations for registered investment funds that are taxed as regulated investment companies (“RICs”) and that invest in wholly owned foreign subsidiaries (or other similar controlled foreign corporations and certain passive foreign investment companies or “PFICs”). The new regulations provide that imputed income from such a foreign subsidiary or PFIC, if derived with respect to the RIC’s business of investing in stocks, securities or currencies, constitutes qualifying income for Subchapter M income tax purposes. The final regulations eliminate a previously proposed requirement that any such imputed income be in all cases annually paid as a dividend by the subsidiary to the RIC. Also, the IRS reconfirmed its previously announced policy that the IRS will no longer provide private letter rulings on questions that require the IRS to determine for purposes of the RIC qualifying income test whether a financial instrument or position is a security under the Investment Company Act of 1940.
All registered investment companies, including mutual funds, exchange-traded funds, and closed-end funds, that have elected for U.S. income tax purposes to be RICs must satisfy various annual qualifying income, asset diversification and minimum distribution requirements under Subchapter M of the Internal Revenue Code. Under the qualifying income requirement, a RIC must derive at least 90% of its gross income from dividends, interest, payments with respect to securities loans, gains from the sale of stock, securities or foreign currencies, allocations from certain publicly-traded partnerships, or other income (including but not limited to gains from options, futures, or forward contracts) derived with respect to the RIC’s business of investing in such stock, securities, or currencies. Certain other Code provisions require RICs and other U.S. corporations, among other taxpayers, to recognize annually as imputed income certain types of net profit recognized by lower-tier controlled foreign corporations or PFICs.
Many RICs have established wholly owned foreign subsidiaries to invest in commodity-related investments. Certain commodity-related investments, such as many commodity index futures and swaps, are not viewed as producing qualifying income for RIC purposes and therefore are not held directly by RICs. As a result, many RICs seeking commodity-related exposure have over time formed wholly owned foreign subsidiaries to hold such investments. Many such RICs obtained IRS private letter rulings approving of such commodity subsidiary structures. In 2006, however, the IRS suspended issuing such rulings to RICs pending an administrative review of the issues involved. In 2016, the IRS proposed tax regulations that, under certain conditions, would have considered imputed income from such foreign subsidiaries and certain other foreign corporations as qualifying income for Subchapter M purposes only if such imputed income were paid out during the same taxable year as a dividend by the foreign subsidiary to the parent fund. The proposed regulations would also have applied the dividend payment requirement to certain imputed income from an investment in a PFIC, such as investment in the equity of certain CLOs. Thus, under the proposed regulations, such imputed income would only have been considered qualifying income to the extent it was paid as a dividend by the PFIC during the same taxable year to the investing fund. This proposed dividend payment requirement was heavily criticized by the investment fund industry as unnecessary and as unworkable in certain situations.
The final tax regulations deleted the dividend payment requirement but otherwise largely adopted the proposed tax regulations without significant change. Thus, the final tax regulations released this week provide that RIC imputed income derived with respect to the RIC’s business of investing in stock, securities or currencies and derived from a foreign subsidiary, such as a controlled foreign corporation, or a PFIC, is treated as RIC qualifying income under the “other income” category even if not distributed as a dividend by the subsidiary. If the imputed income is in fact distributed in the same taxable year by the foreign subsidiary or PFIC, the final regulations treat such income as RIC qualifying income under the “dividend” income category.
Under the final regulations, “global intangible low-taxed income,” or “GILTI,” with respect to a RIC’s investment in a controlled foreign corporation would also appear to be qualifying income to the extent that such inclusions are derived with respect to a RIC’s business of investing in stock, securities, or currencies.
As mentioned above, the IRS has made permanent its current policy that it will no longer issue private letter rulings as to whether particular financial instruments qualify as “securities” for purposes of the RIC qualifying income test. In 2006, the IRS addressed whether certain commodity-related instruments and positions qualified as “securities” for purposes of section 851. Revenue Rulings 2006-1 and 2006-31 provided that certain commodity index derivative contracts were not “securities” for purposes of Code section 851(b)(2), and that therefore income derived from such contracts would not satisfy the qualifying income requirement if held directly by a RIC. The IRS subsequently issued private letter rulings confirming that certain other types of commodity index derivative contracts did constitute “securities” for section 851 purposes and would produce qualifying RIC income. But, after time, the IRS halted issuing such rulings on commodity index derivative contracts pending further review of the issue. Following the review, the IRS ended its policy of providing affirmative guidance as to whether certain commodity index derivative contracts constitute securities for RIC purposes and also revoked its previously issued private rulings to the extent that such rulings related to commodity index derivative contracts. The preamble to the final regulations released this week reconfirms and makes permanent the IRS’ policy that no more private rulings will be issued in this area but also confirms that Revenue Rulings 2006-1 and 2006-31 will not be revoked.
The final regulations apply to taxable years beginning after June 17, 2019, but may be voluntarily relied upon for taxable years beginning after September 28, 2016.