Earlier this month, House Ways and Means Committee chairman, Charles Rangel (D-New York) introduced the Regulated Investment Company Modernization Act of 2009 (“Act”). As its name suggests, the Act would modernize the U.S. federal income tax rules that apply to regulated investment companies (“RICs,” e.g., mutual funds). Two of the Act’s provisions are discussed below.

Commodities Produce Qualifying Income

A RIC must derive at least 90% of its gross income from certain enumerated sources (the “Income Test”). Under current law, direct investments in commodities do not generate qualifying income for purposes of the Income Test. In addition, the IRS ruled a few years ago that derivative contracts providing for a total return exposure to a commodity index also do not generate qualifying income for purposes of the Income Test.

The Act would provide that a RIC’s gains from the sale or other disposition of commodities and other income derived with respect to its business of investing in commodities would be qualifying income for purposes of the Income Test.

Repeal of Preferential Dividend Rule

A RIC is permitted to take a deduction for dividends paid to its shareholders. However, “preferential dividends” are not deductible. A dividend is considered a “preferential dividend” unless it is distributed pro rata to the RIC’s shareholders and with no preference to any share of stock as compared with other shares of the same class and with no preference to one class of stock as compared with another class except to the extent that the class is entitled to such preference. The intricacies of the preferential dividend rule have bedeviled tax practitioners for decades.

The Act would repeal the preferential dividend rule for “publicly offered” RICs. A RIC is considered to be “publicly offered” if its shares are (i) continuously offered pursuant to a public offering, (ii) regularly traded on an established securities market, or (iii) held by or for no fewer than 500 persons at all times during the taxable year.