On March 19, 2019, the Internal Revenue Service (IRS) and Treasury Department (Treasury) issued final regulations (T.D. 9851) (Final Regulations) under section 851 addressing the income test applicable to regulated investment companies (RICs) that hold interests in certain foreign corporations. These final regulations adopt the opposite approach on the income test compared to the proposed regulations (REG-123600-16) (the Proposed Regulations) issued by the IRS and Treasury in 2016. As described in our prior legal alert on the Proposed Regulations, Legal Alert: Reversing Course—Proposed Regulations Reverse IRS Ruling Position on Treatment of Income from CFCs and PFICs for RIC Qualification Purposes, the Proposed Regulations reversed the IRS’s historic ruling position on the application of the RIC income test to the income generated from certain foreign corporations. In response to the Proposed Regulations, David Roby, a partner at Eversheds-Sutherland (US) LLP, provided written comments (the Eversheds Sutherland Comments) to the IRS and Treasury criticizing the Proposed Regulations and recommending that the IRS and Treasury withdraw the Proposed Regulations or revise them to be consistent with the IRS’s historic ruling position. The Final Regulations, consistent with the Eversheds Sutherland Comments, effectively reversed course again to resume the original course reflected in the IRS’s historic ruling position. As a result, the Final Regulations will be a welcome relief to many RICs that have investments in foreign corporations.
The principal issue addressed in the Final Regulations was whether the income inclusions (Income Inclusions) under section 951(a)(1) from controlled foreign corporations (CFCs) and section 1293(a) from passive foreign investment companies (PFICs) that have made Qualifying Electing Fund elections would be qualifying income for purposes of the RIC gross income test set forth in section 851. In this respect, in order to qualify as a RIC, a corporation must, among other things, derive at least 90% of its gross income (90% Gross Income Test) each taxable year from certain specified sources of income, including dividends, interest, gains from the sale of stock or securities, or other income derived with respect to its business of investing in stock of securities (Good RIC Income). The Internal Revenue Code (Code) provides that Income Inclusions from CFCs and PFICs are treated as dividends (and therefore Good RIC Income) for purposes of the 90% Gross Income Test provided that the RIC receives a distribution of the income in the same taxable year to which inclusion relates. It does not specifically provide whether or not these Income Inclusions would be Good RIC Income if no distributions were received from the CFCs or PFICs. As described in more detail in our 2016 Legal Alert, despite the fact that the IRS had issued numerous private rulings concluding that the Income Inclusions from CFCs and PFICs would be Good RIC Income regardless of whether or not the RIC received a distribution of such income in the same taxable year, the Proposed Regulations reversed course from this position and provided that the Income Inclusions from CFCs and PFICs would be Good RIC Income only if the RIC received distributions of such income from the CFCs or PFICs in the same taxable year to which the Income Inclusions relate (Non-qualifying Income Proposal).
The Eversheds Sutherland Comments (along with the written comments of four other commenters) criticized the Non-qualifying Income Proposal and recommended that it not be adopted. Alternatively, the Eversheds Sutherland Comments recommended that the regulations be revised to provide that Income Inclusions from CFCs and PFICs would be treated as “other income” from a RIC’s business of investing in securities. The focus of the Eversheds Sutherland Comments was on business development companies and other RICs that invest in the equity or residual interests of collateralized loan obligations, collateralized debt obligations, and similar securitization vehicles (collectively, CLOs). Among other things, the Eversheds Sutherland Comments noted that while RIC shareholders of wholly owned CFCs can cause such CFCs to make timely distributions, RICs that invest in the equity or residual interests in CLOs generally do not have the ability to control the timing of the distributions from such investments. As a result, RICs that invested in the equity or residual interests in CLOs would be at risk of failing to qualify as RICs if they did not receive timely distributions from CLOs. The Eversheds Sutherland Comments pointed out that this was likely an unintended consequence of the Proposed Regulations since RICs that could control the timing of distributions from CFCs or PFICs would not be impacted by the Proposed Regulations. The Eversheds Sutherland Comments also pointed out that Income Inclusions from CFCs and PFICs are substitutes for dividends and capital gain from the sale of CFC or PFIC stock. As such, the Eversheds Sutherland comments argued that the Income Inclusions effectively represent an advance dividend (or an equivalent amount of advance gain) that should be other income from a RIC’s business of investing in securities.
The IRS and Treasury ultimately accepted the recommendations in the Eversheds Sutherland Comments and the other commenters and provided that the Non-qualifying Income Proposal would not be adopted. Rather, the IRS and Treasury determined that the Final Regulations should instead include an affirmative rule that an Income Inclusion “derived with respect to a corporation’s business of investing in stock, securities, or currencies…is other income” that constitutes Good RIC Income.
Eversheds Sutherland Observation: The reversal of course in the Final Regulations to reject the Non-qualifying Income Proposal and to instead recognize that Income Inclusions from CFCs and RICs may constitute “other income” that is Good RIC Income is based on sound tax policy and will allow RICs that invest in CFCs and PFICs to maintain their qualification as RICs regardless of whether or not they receive current distributions of such income from such CFCs or PFICs. This is especially welcome relief for RICs that invest in the equity or residual interests in CLOs.
At the time they issued the Proposed Regulations, the Treasury and the IRS also issued Rev. Proc. 2016–50 (2016–43 I.R.B. 522), which provided that the issue of whether a financial instrument constitutes a “security” for purposes of the RIC qualification rules in Section 851 is a no-rule issue on which the IRS normally will not issue private letter rulings. Their primary reason for adopting this no-rule position was based on the Code’s reliance on the Investment Company Act of 1940, as amended (1940 Act), to define “securities” for this purpose. Because the Securities and Exchange Commission (SEC) has been granted exclusive rulemaking authority under the 1940 Act, the IRS determined that it should defer to the SEC to determine what constitutes a security under such act. In connection with the adoption of the no-rule position, the IRS asked for comments on whether it should withdraw Rev. Rul. 2006–1 (2006–1 C.B. 261), Rev. Rul. 2006–31 (2006–1 C.B. 1133), and other previously issued guidance involving determinations of whether a financial instrument or position held by an RIC was a security. In the preamble to the Final Regulations, the Treasury and the IRS reaffirmed the no-rule position on the issue of whether an instrument constitutes a security for purposes of the RIC qualification rules, but they agreed not to withdraw their prior published rulings. This will allow RICs to continue to rely on these existing rulings.
Eversheds Sutherland Observation: The issue of what constitutes or does not constitute a security in modern finance can be a difficult issue as bankers continue to create more and more complex derivative instruments. Because this issue is a no-rule position for the IRS based on its desire to defer to the SEC, it will be difficult for RICs to obtain guidance as to whether or not a particular instrument is a security under the 1940 Act since the SEC will be unlikely to provide guidance on exclusively tax issues.