The Internal Revenue Service (the “IRS”) released Private Letter Ruling 200825010 on June 20 in which it ruled that income received by a management investment company registered under the Investment Company Act of 1940, as amended, and segregated into eight separate portfolios (each classified as a regulated investment company or “RIC” under the Internal Revenue Code of 1986, as amended (the “Code”)) from a “qualified settlement fund” as a result of a settlement with its former investment advisor will be treated as qualifying income for purposes of Section 851(b)(2) of the Code. Additionally, the IRS ruled that payments made to shareholders from the qualified settlement fund will not be treated as preferential dividends under Section 562(c) of the Code.
Based on findings regarding material omissions and misrepresentations by the RICs’ former investment advisor and other wrongful acts by both the former investment advisor and its principals related to market timing trading activity in the RICs’ shares, the Securities and Exchange Commission (the “SEC”) imposed an order seeking both the disgorgement of profits and civil penalties. In order to settle the SEC’s claims, the former investment advisor and its principals agreed to pay a sum of money to a “qualified settlement fund.” Pursuant to a distribution plan, the money in the fund will be distributed to shareholders of the RICs as compensation for losses sustained by each during the period in which the market timing trading occurred. The amount of the loss sustained by each shareholder will be determined by first allocating the amounts held in the qualified settlement fund among the RICs based upon the quarterly percentages of the estimated short term profits earned by market timers with respect to each RIC. Such amount will be further allocated to each day in the quarter, and, finally, to each shareholder in proportion to his holdings in each RIC on that particular day. If the total amount allocated to any shareholder is less than a minimum amount, then such shareholder will not receive any distribution from the qualified settlement fund. Rather, the amount allocated to such shareholder will be re-allocated to other shareholders. Certain amounts that are not distributed to the shareholders (e.g., interest earned on amounts held in the fund and amounts intended for shareholders for which settlement checks were never cashed) will be distributed to the RICs.
The IRS ruled that the payments to the RICs relating to the settlement are qualifying income under Section 851(b)(2) of the Code. In so ruling, the IRS determined that the payments relate to the RICs’ business of investing in stock, securities and currencies because the recovery of compensation for losses realized on the sale of portfolio assets in response to frequent requests for redemption by market timers bears a direct relation to the normal course of the RICs’ business. Likewise, the recovery of penalties associated with the recovery of such losses is directly related to the RICs’ normal course of business. Additionally, the IRS ruled that the payment of the settlement proceeds to the affected shareholders of the RICs does not result in preferential dividends under Section 562(c) of the Code.Like all other private rulings, this ruling may not be relied upon by taxpayers other than the one to whom it was issued.