Recently-finalized, regulations provide that, in determining whether a corporation is a regulated investment company (RIC), amounts the corporation is required to include in income as a result of its investment in foreign corporations will qualify as “good income” even if those amounts are not distributed to the corporation. This represents a reversal of the position taken by Treasury and the IRS in 2016 proposed regulations, and reinstates the position the IRS had taken in private letter rulings issued to RICs beginning in 2006. This is a favorable result not only for RICs that invest in wholly-owned foreign subsidiaries to gain exposure to commodity-related or other assets that they cannot hold directly, but also for RICs that invest in foreign corporations where they cannot control the amount or timing of distributions of the corporation’s income.
Background. In order for a corporation to qualify as a RIC, at least 90% of its gross income must be “good income” — that is, income from qualifying sources including dividends, interest, gains from the sale or other disposition of stock or securities, and other income derived with respect to its business of investing in stock, securities or currencies (other income). A RIC must distribute substantially all of its income in order to qualify for favorable tax treatment under the Code.
In certain circumstances, a RIC is required to include in income its share of the earnings of a foreign corporation in which it invests, without regard to whether the foreign corporation makes a distribution to the RIC. This would be the case with respect to a RIC’s investment in a wholly-owned foreign subsidiary, which would be a controlled foreign corporation (CFC), or a RIC’s investment in a passive foreign investment company (PFIC) with respect to which the RIC made a qualifying electing fund election.
Although these inclusions are technically not dividends, the Code provides that the inclusions would be treated as good dividend income to the extent accompanied by a distribution out of the earnings and profits of the CFC or PFIC. The Code is silent as to the treatment of such income inclusions in the absence of a corresponding distribution.
The IRS’ changing positions. Beginning in 2006, the IRS issued a series of private letter rulings to RICs providing that the income inclusion from a CFC would be treated as good “other income” for purposes of the income test, even if not distributed to the RIC. The IRS stopped issuing such rulings in 2011, and the 2016 proposed regulations provided that income inclusions from a CFC or PFIC would be good income only to the extent distributed to the RIC. If not distributed, the income would not qualify as good “other income.”
The IRS reversed its position in the final regulations, which provide that income inclusions from a CFC or PFIC that are derived with respect to a RIC’s business of investing in stocks, securities or currencies are good “other income” even if not distributed.
The distribution requirement must still be met. While the final regulations are a favorable development with respect to the treatment of income inclusions from CFCs and PFICs that are not accompanied by a corresponding distribution, RICs are still required to take these income inclusions into account in determining the amount they must distribute in order to satisfy the requirement that they distribute 90% of their income.
Effective date. Taxpayers can rely on this provision of the final regulations for taxable years that begin after Sept. 28, 2016.
Definition of “security.” The 2016 proposed regulations provided that the IRS would no longer issue private letter rulings on questions relating to the treatment of a corporation as a RIC that require a determination of whether a financial instrument or position is a “security” under the Investment Company Act of 1940 (the 40 Act). The IRS issued a Revenue Procedure to the same effect at the same time the proposed regulations were issued. This position is retained in the final regulations, although the IRS is not withdrawing prior guidance involving determinations of whether a financial instrument or position held by a RIC is a security under the 40 Act.