The IRS recently provided relief from the RIC distribution requirement for money market funds that receive contributions in connection with the transition to a floating NAV, enabling RICs to top up their NAVs without having to distribute the contributions; the IRS also provided guidance on the application of the insurance company separate account diversification requirements to government money market funds.
The Internal Revenue Service (IRS) recently issued two pieces of guidance that relate to the 2014 money market fund (MMF) reform rules issued by the US Securities and Exchange Commission (SEC):
- Revenue Procedure 2016-31 provides temporary relief from the distribution requirement generally applicable to regulated investment companies (RICs) under Section 852(a)(1) of the Internal Revenue Code of 1986, as amended (the Code).
- Notice 2016-32 provides guidance to taxpayers regarding the diversification requirements applicable to certain insurance company segregated asset accounts under Section 817(h) of the Code.
SEC MMF Reform Background
In 2014, the SEC amended certain rules applicable to MMFs. Under pre-existing SEC rules, MMFs are allowed to round their net asset values (NAVs) to the nearest percentage point. Under the amended SEC rules, certain MMFs (“floating-NAV MMFs”) will be required to round their price per share to the nearest basis point (or one one-hundredth of a cent). Under the amended rules, “government MMFs” and “retail MMFs” are not required to be floating-NAV MMFs. A “government MMF” is an MMF that invests at least 99.5% of its assets in cash, government securities, and repurchase agreements collateralized fully with cash or government securities. A “retail MMF” is an MMF that has policies and procedures reasonably designed to limit all of its beneficial owners to natural persons. Government and retail MMFs (“stable-NAV MMFs”) may continue to round their NAVs to the nearest percentage point. See our September 2014 White Paper “The New Era of Money Market Fund Regulation” for a more detailed description of the amended SEC rules.
MMFs that are required to be floating-NAV MMFs under the amended SEC rules will generally be required to move to a floating NAV no later than October 14, 2016. An MMF that converts into a floating-NAV MMF might receive a contribution that will raise its NAV to $1.0000 before the MMF’s NAV begins to float (a “top-up contribution”).
Revenue Procedure 2016-31
Revenue Procedure 2016-31 provides relief in connection with top-up contributions to MMFs that convert into floating-NAV MMFs. Code Section 852(a)(1) generally provides that a RIC is not subject to tax treatment generally applicable to RICs unless it distributes at least 90% of its “investment company taxable income” (ICTI). A RIC’s distributions reduce its NAV. Thus, if a top-up contribution to a RIC were to be included in the RIC’s ICTI for purposes of the Section 852(a)(1) distribution requirement, then the top-up contribution (taking into account expenses and RIC-level taxes) might need to be more than ten times the amount that would have been necessary absent the distribution requirement—because almost all the money contributed (increasing the NAV) would need to be distributed (decreasing the NAV).
If an MMF that qualifies as a RIC receives a top-up contribution within the scope of the revenue procedure, the IRS will not challenge the treatment of the contribution as an amount that is included in ICTI for purposes of Code Section 852(b)(2) but excluded from ICTI for purposes of the Code Section 852(a)(1) distribution requirement. Code Section 852(b)(2) is the general definition of ICTI, which applies for purposes of the calculation of RIC-level income tax. The revenue procedure thus establishes that the IRS will not challenge an MMF’s eligibility for tax treatment as a RIC as a result of a failure to distribute a top-up contribution if the top‑up contribution is within the scope of the revenue procedure and the MMF pays tax (at rates of up to 35%) on the top-up contribution. Because the tax that a RIC pays to the IRS in respect of a top-up contribution will reduce the RIC’s NAV, the top-up contribution will need to be grossed up for the tax paid in order to accomplish the goal of moving the RIC’s NAV up to $1.0000.
The precise scope of the revenue procedure is not entirely clear. In particular, the revenue procedure does not clearly indicate whether top-up contributions received in connection with transactions other than conversions into floating-NAV MMFs (e.g., reorganizations described in Section 368(a) of the Code or liquidations) were intended to fall within its scope. The revenue procedure refers to the SEC’s statements that it will not object to a failure to report (on Form N‑CR) top-up contributions that occur “as part of a transition for [MMFs] to implement the floating NAV reform before the October 14, 2016, compliance deadline.” That language appears to be drawn directly from the SEC’s responses to frequently asked questions posted online regarding the amended SEC rules (SEC FAQs), which include limited references to transactions other than conversions of stable-NAV MMFs into floating-NAV MMFs; however, it is not clear whether the reference to a “transition” refers to each MMF’s transition (e.g., conversion into a floating-NAV MMF) or to the market-wide transition under the floating NAV reform. Moreover, assuming that the reference to a “transition” refers to each MMF’s transition, it is not clear whether the reference could refer to transitions other than conversions to floating-NAV MMFs.
Notably, Revenue Procedure 2016-31 also does not provide guidance as to the specific character of the top-up contribution, but it appears to be consistent with the IRS’s prior guidance on this issue in Revenue Procedure 2009-10. Revenue Procedure 2009-10 treated certain top-up contributions received before January 1, 2010 as generating short-term capital gain (i.e., a component of ICTI) to the RICs receiving them. Because the RICs that relied on Revenue Procedure 2009-10 generally had capital losses available to offset the short-term capital gain, the top-up contributions at issue in Revenue Procedure 2009-10 generally did not result in net taxable income, which allowed the RICs in question to top up their respective NAVs without triggering the Section 852(a)(1) distribution requirement. There are also arguments for excluding certain top-up contributions from ICTI for all purposes, e.g., by treating the top-up contributions as non-shareholder contributions to capital. At least one commenter on 2014 proposed regulations in this context suggested that top-up contributions should result in neither income nor gain to MMFs. Nevertheless, Revenue Procedure 2016-31 states that the US Department of the Treasury and the IRS “do not believe the contributions should be excluded from the RIC’s income for [purposes other than the distribution requirement].” Consistent with that belief, Revenue Procedure 2016-31 offers a safe harbor for certain top-up contributions that are grossed up to cover RIC‑level tax. RICs receiving top-up contributions are not required to utilize the revenue procedure, which leaves flexibility for RICs to potentially take different positions in connection with top-up contributions.
Revenue Procedure 2016-31 does not refer to a specific legal authority to support the substance of the relief provided. In particular, it refers to no substantive authority for excluding an item from ICTI for only one Code provision while including it in ICTI for all other provisions. This suggests that the revenue procedure represents the IRS’s attempt to be accommodating in connection with the SEC rule changes. For that reason, the relief offered by the revenue procedure seems likely to be available only to MMFs that are eligible for it under the terms and requirements of the revenue procedure, although the uncertain scope of the revenue procedure (discussed above) complicates this analysis.
Revenue Procedure 2016-31 also provides guidance on the application of the Code Section 4982 excise tax in connection with top-up contributions. Code Section 4982 generally imposes a 4% excise tax on the excess of a RIC’s “required distribution” for a calendar year over its “distributed amount” for the calendar year. A RIC’s “required distribution” for a calendar year generally equals the sum of 98% of its ordinary income and 98.2% of its capital gain net income for the one-year period ending on October 31 of the calendar year. A RIC’s “distributed amount” is generally the sum of the RIC’s deductions for dividends paid during the calendar year and any amount on which income tax is imposed for a taxable year ending in the calendar year. Under Code Section 4982(c)(4), however, if a RIC is subject to income tax on an amount for a taxable year and makes estimated tax payments in respect of that amount during the calendar year in which that taxable year begins, then the RIC may elect to include that amount in its “distributed amount” for the calendar year in which the taxable year begins (and not for the following calendar year, as would be required under the general definition of “distributed amount”).
The IRS likely expects that fiscal-year RICs that avail themselves of Revenue Procedure 2016-31 will make Code Section 4982(c)(4) elections and make estimated tax payments in respect of top-up contributions. If an MMF availing itself of the revenue procedure fails to make the Code Section 4982(c)(4) election or fails to make an estimated tax payment, then the MMF may be subject to excise tax in connection with the top-up contribution.
The IRS did not provide guidance as to the deductibility of the top‑up contribution to the adviser that makes the payment; however, it appears that the IRS anticipates that advisers will take the position that the payment is deductible on their tax returns and believes that making top-up contributions taxable to RICs is consistent with general tax symmetry principles.
Revenue Procedure 2016-31 applies to top-up contributions made before October 14, 2016.
Notice 2016-32 provides guidance on how the Code Section 817(h) diversification requirements (which apply to certain insurance company “segregated asset accounts”) should apply to investments in government MMFs. Only a small number of US agencies and instrumentalities issue securities that may be held by a government MMF under applicable SEC rules. Moreover, it is expected that certain MMFs will convert into government MMFs in connection with the amended SEC rules applicable to MMFs. The increased demand for government securities arising from these conversions, coupled with the already small number of US government issuers, may make it increasingly difficult for MMFs to qualify as government MMFs and satisfy the Code Section 817 diversification requirements. The notice responds to these concerns.
Certain variable insurance and annuity contracts are not eligible for the favorable tax treatment accorded to insurance and annuity contracts under the Code unless they are funded by segregated asset accounts that are adequately diversified under applicable Treasury regulations. In general, whether a segregated asset account is adequately diversified for this purpose is determined under a test that measures the concentration of the account’s assets in any four or fewer investments. To meet the test, each segregated asset account must generally hold securities of at least five issuers, in appropriate proportions. All securities of a single issuer are generally treated as a single investment under the test, and in the case of US government securities, each government agency or instrumentality is treated as a separate issuer.
For purposes of the Code Section 817 diversification test, segregated asset accounts are permitted to “look through” certain types of entities as long as, in general, all beneficial interests in the entities are held by segregated asset accounts used to fund variable insurance and annuity contracts (and certain other permitted investors), and public access to the entities is available exclusively through those contracts (and other permitted investors). There are many entities (including entities structured as RICs and partnerships for tax purposes) that are intended to qualify for look-through treatment under this test. Each such entity typically seeks to comply with the Code Section 817 diversification test so that any segregated asset account that invests all of its assets in the entity would meet the diversification test on a look-through basis.
To ease the difficulties associated with both increased demand for government securities and the small number of US government issuers, the notice provides that a segregated asset account is adequately diversified if (1) no policyholder has investor control and (2) either (a) the account itself is a government MMF or (b) the account invests all of its assets in an entity that qualifies as a government MMF and that qualifies for the look-through treatment described above.
The Treasury Department and IRS intend to amend the applicable regulations in this context. Pending future administrative or regulatory guidance, taxpayers may rely on Notice 2016-32.