Alert January 11, 2011

President Signs Regulated Investment Company (RIC) Modernization Act Updating Tax Treatment of RICs

On December 22, 2010 President Obama signed into law the Regulated Investment Company Modernization Act of 2010 (“RMA”).  The bill updates the tax regime that applies to Regulated Investment Companies (“RICs”), implementing an array of changes that are generally favorable for RICs, including changes designed to accommodate non-calendar-year RICs and RICs in fund-of-funds structures.  Other notable changes include the repeal of the preferential dividend rule for publicly-offered RICs and implementation of savings provisions to make loss of RIC status less likely.  The principal features of the RMA are summarized below. 

Unlimited capital loss carryovers.  Previously, net capital losses for RICs could be carried over only for eight years and were treated as short-term capital losses in each of those years.  The RMA changes this regime going forward, so that net capital losses starting in 2011 are allocated between long-term and short-term capital losses, which may be carried forward without limitation, similar to the rules that apply to individual taxpayers. 

Savings provisions for failures to meet income and asset tests.  To qualify as a RIC, a company is limited in the assets it can hold and the income it may earn.  The RMA implements savings provisions that allow RICs to correct certain failures to satisfy the income and asset tests, thereby avoiding loss of RIC status. 

For de minimis failures to meet the asset test (defined as failures resulting from the ownership of assets not exceeding the lesser of 1% of the RIC’s total assets or $10 million), a RIC will be considered to have met the test if it meets the requirements of the asset test within six months of the last day of the quarter within which the RIC identifies that it failed the test.  For other failures to meet the asset test that are due to reasonable cause and not willful neglect, a RIC may maintain its status by disclosing the assets that caused the failure, correcting the failure within six months, and paying an excise tax equal to the greater of $50,000 or the highest rate of tax specified in Section 11 of the Internal Revenue Code (“IRC”) upon the net income generated by the assets that caused the failure. 

Failure to meet the income test, if due to reasonable cause and not willful neglect, may now be cured by disclosing each item of gross income and paying an effective 100% tax on the amounts of income that caused the failure. 

Modification of rules relating to dividends and other distributions.  The RMA contains nine provisions reforming the rules relating to dividends and distributions.  Many of these rules are designed to accommodate non-calendar-year RICs and fund-of-funds structures.  

  1. An alternative method of correcting for incorrect designations of special dividends (such as capital gain dividends) on Form 1099s has been provided to reduce the likelihood that shareholders will be required to file amended returns.  This is relevant for RICs that are not calendar year taxpayers, since the problem would tend to arise when certain types of income for the post-December 31 portion of their fiscal year, unknown at the time, affected what shareholders were entitled to report for their own calendar year.  In general, if it is possible to correct the designation with modifications to designations of special dividends for the shareholder’s subsequent taxable year, the RMA provides a mechanism for RICs to do so.  This provision also replaces the former designation requirement for capital gain dividends with a reporting requirement, which may be satisfied by Form 1099. 
  2. The RMA allows for certain disallowed deductions associated with tax-exempt income to be taken into account in calculating a RIC’s earnings and profits.  This fixes an inappropriate result that formerly could occur when RICs investing in tax-exempt bonds distributed an amount that economically was a return of capital to shareholders, but under former law would have been classified as a dividend out of earnings and profits. 
  3. The RMA allows more flexibility for fund-of-funds structures to pass through exempt‑interest dividends and foreign tax credits to shareholders.  The requirement that more than 50% of a RIC’s assets be comprised of municipal bonds (in the case of exempt-interest income) or of stock and securities of foreign corporations (in the case of foreign tax credits) was problematic for the top-tier fund in fund-of-funds structures.  The 50% requirement no longer applies to a fund-of-funds that invests 95% of its assets in cash, cash items, and interests in other RICs. 
  4. The RMA allows more flexibility for RICs to make spillback dividends, but limits the time period for making such dividends.  Spillback dividends are those which are declared in a taxable year and used to calculate the dividends-paid deduction for that taxable year, but are not actually paid until the subsequent year.  Previously, RICs were required to pay spillback dividends no later than the payment of the next regular dividend, and within twelve months.  The RMA allows RICs to make spillback dividends with the first payment of the same type of dividend, but also generally limits the time period to nine months and fifteen days. 
  5. The RMA makes it easier for non-calendar-year RICs to distribute all their income and avoid the excise tax without inadvertently making a return-of-capital distribution, which can create confusion for shareholders who then receive amended information returns and cost-basis statements.  Earnings and profits of a RIC are now allocated first to pre‑January 1 distributions, instead of being allocated pro-rata over all the distributions during the RIC’s taxable year. 
  6. The RMA exempts publicly-offered RICs from the requirement that they determine whether a distribution is “essentially equivalent to a dividend,” so that all publicly‑offered RICs with shares redeemable upon demand may automatically treat distributions in redemption of stock as exchanges and not dividends. 
  7. The RMA repeals the preferential dividend rule for publicly-offered RICs, a rule which had, according to Congress, “largely served as an unintended trap for mutual funds that make inadvertent processing or computational errors.”  The IRC no longer will disallow a dividends-paid deduction for preferential dividends.  Securities laws which were passed subsequent to the initial enactment of the preferential dividend rule are now presumed to independently protect investors. 
  8. The RMA allows RICs to defer late-year losses to avoid the need for shareholders of non-calendar-year RICs to receive amended information returns and cost-basis statements.  Under former law, if a RIC suffered certain late-year losses, the RIC’s taxable income, net capital gain, or earnings and profits could have been affected in a way that changed what should have been reported to shareholders.  RICs may now elect to treat certain late-year losses as arising on the first day of the RIC’s next taxable year. 
  9. The RMA exempts shareholders of certain “daily dividend companies” from a rule disallowing losses on the sale or exchange of RIC stock held for six months or less to the extent that the shareholder previously received an exempt-interest dividend.  RICs and their shareholders may escape the application of this rule by declaring dividends on a daily basis in an amount equal to at least 90% of net tax-exempt interest, and distributing such dividends at least monthly. 

Modification of rules related to the RIC excise tax.  The RMA contains three provisions allowing RICs to better avoid the excise tax imposed for failure to distribute sufficient income in a calendar year.  In addition, the RMA increases the required distribution percentage of net capital gain income from 98% to 98.2%. 

  • The RMA extends an excise tax exemption for RICs with tax-exempt shareholders.   Formerly, this exemption applied only to RICs in which all shareholders were 401(a) trusts or segregated accounts underlying variable insurance contracts.  Now, RICs owned by other tax-exempt pension and retirement plans are also exempt from the excise tax. 
  • The RMA expands a rule allowing RICs to treat certain ordinary income derived after October 31 as arising on the first day of the following calendar year, a rule intended to allow RICs some flexibility in determining how much they should distribute to shareholders.  The RMA now allows ordinary gains or losses from the sale, exchange, or other disposition of property, including foreign currency gains or losses, to be similarly deferred. 
  • The RMA accommodates non-calendar-year RICs electing to pay tax on gain from market discount bonds to avoid making a taxable distribution to shareholders.  RICs may make quarterly estimated tax payments, and treat the amount on which tax is paid as distributed for purposes of the excise tax.  Formerly, the deemed distribution was not deemed to occur until the end of the taxable year.  Now, certain quarterly estimated tax payments may be taken into account as they are made to cause the underlying amounts to be deemed as distributed for the purposes of the excise tax. 

Miscellaneous provisions.  The RMA contains two miscellaneous provisions.  First, the RMA aligns the deficiency dividend penalties applying to RICs with the more lenient penalties applying to REITs.  Now, only an interest charge is applied, instead of an interest charge and an additional penalty. 

Finally, the RMA implements a time limitation on the rule that shareholders increase their basis in RIC stock by the amount of a load charge paid with respect to previously owned RIC stock.  This rule was formerly not time-limited, which Congress found to create administrative problems due to its potential application after the passage of many years.  The application of this rule is now limited to RIC stock acquired before January 31 of the calendar year following the disposition of the RIC stock that bore the load charge.