The Treasury Department and the IRS recently issued proposed regulations (REG-123600-16) that provide guidance on the requirements a corporation must satisfy to qualify as a regulated investment company (RIC).
Two of the requirements that a corporation must satisfy to be treated as an RIC are a gross income test under Section 851(b)(2) (the RIC Income Test) and an asset diversification test under Section 851(b)(3) (the RIC Asset Test). The RIC Income Test provides that at least 90% of a RIC’s income must be derived from a source list that includes dividends, interest, sale of stock or securities, and other income derived with respect to its business of investing in stock, securities or currencies. The RIC Asset Test provides that at least 50% of the value of a RIC’s assets must be made up of cash, securities and other similar assets.
For purposes of both the RIC Income Test and the RIC Asset Test, Section 851 defines securities by reference to the Investment Act of 1940 (the 1940 Act). In 2006, the IRS issued Rev. Rul. 2006-1, which ruled that a derivative with respect to a commodity was not a security for RIC qualification purposes. That same year, the IRS issued Rev. Rul. 2006-31, which clarified that not all instruments that provided commodities exposure were foreclosed from being treated as securities for RIC qualification purposes.
The preamble to the proposed regulations emphasizes that any future guidance regarding whether particular financial instruments are securities for purposes of the 1940 Act is within the jurisdiction of the SEC rather than the IRS. Concurrently with the issuance of the proposed regulations, the IRS stated in Revenue Procedure 2016-50 that it will not ordinarily issue letter rulings or determination letters that require a determination of whether a financial instrument or position is a security as defined in the 1940 Act.
Section 851 provides that a RIC may treat income of a foreign corporation included in the RIC’s income under Section 951(a)(1)(A)(i) or Section 1293(a) as a dividend for purposes of the RIC Income Test, as long as there is a distribution from the foreign corporation’s earnings and profits that’s attributable to the amount included. In the past, the IRS has issued private letter rulings allowing RICs to count those inclusions toward the 90% threshold of the RIC Income Test, even without corresponding distributions, by treating the inclusions as other income derived with respect to the business of investing in stocks, securities or currencies. The proposed regulations provide that an inclusion under Section 951(a)(1)(A)(i) or Section 1293(a) cannot be treated as falling within that other income category.
Partner, Washington National Tax Office
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Partner, Washington National Tax Office
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