The U.S. House of Representatives September 28, 2010, passed HR 4337, the Regulated Investment Company Modernization Act of 2010 (the Act), which, if enacted into law, would significantly change the taxation of regulated investment companies (RICs). The Senate has not yet taken up the bill, which is not viewed as controversial. Whether the bill will be passed and, if so, when, is uncertain at this time.
Some of the more significant changes in the Act and the practical implications of those changes include the following.
- Expansion of the Definition of Qualifying Income. In order to avoid corporate-level taxation, at least 90 percent of a RIC’s income each year must consist of certain qualifying income. Income from trading in commodities does not constitute qualifying income under current law. In 2006 the Internal Revenue Service also ruled that income from commodity-based swaps also did not constitute qualifying income. For this reason, registered investment companies that purchase material amounts of commodities and commoditylinked derivatives often must do so through structured notes and/or through the use of foreign corporate subsidiaries, which convert the “bad” income into qualifying dividend income. The Act provides that gains from commodities (including foreign currencies), commodity-linked derivatives and futures contracts on commodities will be considered qualifying income. This change would simplify the structure of funds that trade or wish to trade commodities. The Act would not, however, change commodities into “qualifying assets” for purposes of satisfying the quarterly diversification test in the Internal Revenue Code of 1986, as amended. At the end of each quarter, no more than 50 percent of a RIC’s assets could be commodities and at least 50 percent of its assets must be cash, cash equivalents and qualifying securities. While the Act expands a RIC’s ability to invest directly in commodities and commodity-linked derivatives, a cap on the amount of these assets will still exist. Nevertheless, for RICs, the ability to invest more significantly in commodities and commodity-linked derivatives likely will expand the types of fund offerings. The Commodity Futures Trading Commission (CFTC) also is currently contemplating a rule proposal that, if adopted, could require RICs that are marketed as managed futures funds to be regulated by the CFTC as commodity pools.
- Elimination of Preferential Dividend Rule. The Act also would remove the preferential dividend rule with respect to a significant number of RICs, thereby creating fewer tax traps for the unwary. A RIC is entitled to a deduction for dividends paid in computing its taxable income and must have a dividends-paid deduction equal to at least 90 percent of its “Investment Company Taxable Income” each year. No dividends-paid deduction is allowed for a dividend deemed by the IRS to be a “preferential dividend,” however. The IRS has maintained that charging different advisory fees and, in certain cases, different expenses to different classes of shares may result in preferential dividends, which could create a qualification problem. The Act eliminates the preferential dividend rule for publicly traded RICs. A publicly traded RIC is one that has shares that are continuously offered pursuant to a public offering, are regularly traded on an established exchange or are held by at least 500 persons at all times during the taxable year. While this provision could allow different advisory fees to be charged to different classes of shares, from a federal income tax perspective, Section 18 of the Investment Company Act of 1940 would still prevent a RIC from charging disparate advisory fees and certain other expenses. Nevertheless, an inadvertent preferential dividend issue may have major tax consequences and elimination of the preferential dividend rule therefore would be a welcome change for RICs.
- Capital Loss Carryovers. Under current law, a capital loss carryover of a RIC expires after eight years and is treated as a short term capital loss. Under the Act, a capital loss carryover does not expire and the loss retains its character as short term or long term. As a result, RICs will no longer have to be concerned about tax planning to avoid the expiration and loss of capital loss carryovers
- Capital Gain Dividend Reporting. Current law requires that capital gain dividends must be designated in a written notice mailed to shareholders within 60 days of the year end. The Act requires that capital gain dividends be reported rather than designated and provides that including the information on a Form 1099 meets the reporting requirement. This change will simplify the reporting of capital gains and should reduce funds’ reporting costs.
- Allocation of Income by Fiscal Year RIC. In order to reduce the need for amended Forms 1099 and amended tax returns by shareholders, the Act allows a RIC with a fiscal year other than the calendar year that has made excess distributions of certain types of income in a calendar year to allocate the excess amounts to the next calendar year. The types of income to which this applies are capital gain dividends, exempt-interest dividends and certain distributions to non-resident aliens.
- Pass Through of Credits and Exempt Interest Income by Fund of Funds. In order to pass through foreign tax credits and tax-exempt interest dividends, a certain portion of a RIC’s assets or income must consist of qualifying items. Under current law, a fund of funds often will not meet the test even though the underlying funds in which it invests will qualify. The Act would allow a fund of funds to pass through those items from underlying funds that meet the requirements. As a result, a fund of funds can be more tax efficient and may allocate its investments through underlying funds without fear of losing the benefit of foreign tax credits or exempt interest earned by the underlying funds.
- Spillover Dividends. The Act would extend the period during which spillover dividends may be paid, allowing RICs more flexibility to correct any underdistribution of income.
- Inadvertent Violations. The Act would provide that inadvertent failures to meet the RIC asset test or income test will not disqualify the RIC. Instead the RIC could avoid disqualification by disclosing and correcting the violation and paying a penalty. De minimis violations of the asset test could be fixed without penalty if corrected within six months of discovery.
In general, the provisions of the Act, if enacted, will be effective for taxable years or in certain cases, calendar years beginning after the date of enactment.