On September 27, 2016, the Internal Revenue Service (IRS) issued proposed regulations that would require commodity subsidiaries of registered investment companies (funds) to currently distribute their income in order for such income to be treated as qualifying income for purposes of Subchapter M of the Internal Revenue Code of 1986, as amended (the Code) and a fund’s treatment as a “regulated investment company” (RIC) thereunder.
In order to qualify as a RIC under Subchapter M of the Code, a fund must derive at least ninety percent of its gross income from certain specified sources (qualifying income). Income from commodities and commodity-related investments is generally not qualifying income. In order to gain exposure to commodities and commodity-related investments, many funds form wholly-owned offshore subsidiaries treated as controlled foreign corporations (CFCs) for federal income tax purposes that invest in commodities and commodity-related investments. Under the CFC rules, the income of the subsidiary generally constitutes “subpart F income” that the fund is required to include in its gross income each year regardless of whether the subsidiary actually distributes the income to the fund. From 2006 to 2011, the IRS issued several private letter rulings where it ruled that the deemed income inclusions from the CFC were qualifying income even if the amounts were not currently distributed to the fund. In July 2011, however, the IRS suspended the further issuance of such private letter rulings pending its further review of the issue.
The proposed regulations modify the IRS’ holding in the private letter rulings. Under the proposed regulations, income inclusions under the CFC rules would be treated as dividends, and therefore qualifying income, only to the extent the fund receives a current distribution out of the subsidiary’s earnings and profits attributable to the income inclusion. Income inclusions that are not matched by actual distributions would not constitute qualifying income. Thus, in order to generate qualifying income, a commodity subsidiary of a fund would need to make an actual distribution of the income to the fund out of its earnings and profits. If the subsidiary does not make such a matching distribution, the fund would still have to include the income inclusion in its gross income but such inclusion would not be qualifying income and, therefore, could jeopardize the fund’s status as a RIC. The proposed regulations do not address “round-tripping” distributions (e.g., where the subsidiary makes a distribution to the fund, which immediately contributes the same amount to the subsidiary), but under general federal income tax rules, such distributions could be disregarded, resulting in the income inclusion not being qualifying income. The proposed regulations would apply to taxable years that begin on or after the date that is 90 days after the date of publication of final regulations in the Federal Register.
In conjunction with the proposed regulations, the IRS also released Revenue Procedure 2016-50 in which it announced that it will no longer issue private letter rulings on whether a financial instrument or position is a security as defined in the 1940 Act. This determination is often important in determining whether income from a financial instrument is qualifying income.