Alert September 29, 2016

IRS Addresses RIC Qualification Matters Related to Derivatives and Use of Blocker Corporations


On Wednesday, September 28, the IRS and Treasury Department proposed regulations under Section 851 of the Code that, if finalized, could prospectively invalidate dozens of private letter rulings treating subpart F and passive foreign investment company (PFIC) inclusions as regulated investment company (RIC) qualifying income without regard to whether the relevant offshore corporation makes a distribution to the RIC out of its earnings and profits (e&p) attributable to such inclusion during the taxable year.1 The regulations, if finalized, would clarify that subpart F and PFIC inclusions are neither “dividends” nor other qualifying income for RICs in the absence of such a distribution. The preamble to the proposed regulations states that the distribution requirement is unambiguous under Section 851, notwithstanding that the IRS has previously granted private letter rulings to RICs concluding otherwise.

More immediately, the preamble to the proposed regulations, along with a companion Revenue Procedure 2016-50, formalize the IRS's current “no rule” policy regarding all RIC qualification issues arising from a RIC’s investment in certain financial instruments. In particular, practitioners have raised questions regarding the treatment of derivatives for purposes of the asset diversification test in Section 851(b)(3) (which effectively limits a RIC’s exposure to any particular issuer, raising the question of who the issuer is in the case of a derivative such as, for example, a swap), and the proper scope of the “other income” clause in the Section 851(b)(2) income test (which has been widely understood to treat all income and gains from derivatives as qualifying income). Unfortunately, such questions will not be addressed at this time by the IRS.

The treatment of derivatives referencing commodities has been in doubt since the IRS, in July 2011, notified RICs with pending private letter ruling requests regarding the treatment of commodity-related investments (specifically, equity linked notes referencing commodities and non-U.S. “blocker” structures set up to hold RICs’ investments in commodities) of a “pause” in granting such requests. The preamble to the proposed regulations and companion Revenue Procedure provide that unless unique and compelling reasons are demonstrated, the IRS will not grant pending or new requests for private letter rulings on any RIC qualification matter “requiring a determination of whether a financial instrument or position is a ‘security’ under the 1940 Act.” The IRS no-rule policy may therefore not be limited to derivatives referencing commodities.

Implications for RICs

A RIC that has been granted a private letter ruling regarding the treatment of subpart F income or PFIC inclusions, or otherwise structured its activities based on the premise that such income will be treated as RIC qualifying income even in the absence of a qualifying distribution, should consider implementing a distribution policy for any CFCs or PFICs it owns. Alternatively, RICs using such structures that do not implement a distribution policy should consider the possible need to unwind such structures if and when the proposed regulations are finalized. Additionally, RICs that have not been granted private letter rulings regarding the treatment of such structures should consider whether the strong language of the proposed regulations creates a negative inference as to the treatment of such structures under current law, notwithstanding the proposed prospective effective date of any final regulations.

The IRS has stated that future guidance will be provided on the meaning of the term “distribution” for purposes of the proposed regulations, which include a reference to Treasury Regulation 1.959-3 indicating that in order to meet the distribution requirement a CFC, for example, may need to make a distribution out of its e&p that exceeds the amount of the RIC’s subpart F inclusion.

RICs with significant investments in derivatives should also consider revisiting their analysis of such derivatives for purposes of the RIC qualifying income and asset tests in light of the announced no-rule policy of the IRS, in particular if RICs have based their analysis on prior IRS interpretations, whether explicit or implicit, of what is a 1940 Act security.

Other Implications

The preamble to the proposed regulations states that “absent a distribution, there is no support in the Code for treating [a subpart F or PFIC inclusion] as a dividend under Section 851.” Although the proposed regulations do not explicitly address the treatment of subpart F and PFIC inclusions in other Code Sections, the expressed views of the IRS in the RIC context raise questions as to how subpart F and PFIC inclusions should be treated in other contexts.

For example, the qualifying income test for publicly traded partnerships in Section 7704(d)(4) provides that PTP qualifying income includes any income that would qualify under Section 851(b)(2)(A) or Section 856(c)(2) (the qualifying income rules for REITs). The IRS has previously granted private letter rulings to PTPs treating subpart F inclusions as qualifying PTP income without regard to distributions from a CFC based on such income’s qualification under Section 851(b)(2)(A).2 Recent private letter rulings granted to REITs by the IRS have treated subpart F and PFIC inclusions as REIT qualifying income on the basis of the IRS’s discretionary authority in Section 856(c)(5)(J),3 which applies to income that does not otherwise qualify under Section 856(c)(2) or (3). Additionally, the IRS has previously granted private letter rulings that subpart F income is not unrelated business taxable income (UBTI) under Section 512(b)(1), most recently on the explicit basis that subpart F income is dividend income for purposes of that Code Section.4

Similarly, although the IRS’s no-rule policy announced in the proposed regulations is limited to RIC qualification matters arising under Section 851, the proposed regulations cite the grant of “exclusive rulemaking authority under the 1940 Act to the Securities and Exchange Commission, including ‘defining accounting, technical and trade terms’ used in the 1940 Act” and conclude that “any future guidance regarding whether particular financial instruments… are securities for purposes of the 1940 Act is therefore within the jurisdiction of the SEC,” therefore raising questions as to the authority of prior IRS interpretations of what is a 1940 Act security in other contexts.


As explained above, RICs, and other taxpayers (including, for example, PTPs) using blocker structures or otherwise investing in CFCs or PFICs that do not currently satisfy the distribution requirement in the proposed regulations should consider implementing a distribution policy with respect to any such CFC or PFIC. RICs, and other taxpayers relying on the treatment of a financial instrument or position as a 1940 Act security, should consider revisiting their analysis of such instruments and positions in light of the IRS’s statements in support of its broad no rule policy.

For further information please contact Robert Kester at (617) 570-1681.

1  See Rev. Proc. 2016-1, Section 11.04(4) stating that a private letter ruling may be “revoked or modified by the issuance of temporary or final regulations.”
2  See, e.g., PLR 200722007, PLR 201113018.
3  See, e.g., PLR 201605005.
4  See, e.g., PLR 200623069, PLR 201430017 (“Furthermore, you state that the [CFC] will derive at least 95 percent of its income for passive investments within the meaning of [Section] 954(c)(1)(A), which defines ‘personal holding company income’ as the portion of gross income which consists of dividends, interest, royalties, rents, and annuities. Accordingly, [subpart F] income received from the [CFC] will be dividend income and therefore will be excluded from the computation of UBTI under [Section] 512(b)(1).”)