The IRS has issued final regulations (T.D. 9851
) that provide guidance on the requirements a corporation must satisfy to qualify as a regulated investment company (RIC). The final rules partially affirm proposed regulations issued in September 2016, but also include significant changes.
One of the requirements that a corporation must satisfy to be treated as a RIC is a gross income test under Section 851(b)(2). The RIC income test provides that at least 90%of a RIC’s income must be derived from a list of sources 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.
For purposes of the RIC income test, Section 851 defines securities by reference to the Investment Act of 1940. 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 provide commodities exposure were foreclosed from being treated as securities for RIC qualification purposes.
The preamble to the proposed RIC regulations emphasized 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 Rev. Proc. 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. The IRS also sought comments on whether previously issued guidance on the definition of security should be withdrawn.
Under the final regulations, the definition of “security” under the 1940 Act remains a no-rule area. However, the IRS chose not to withdraw previously issued guidance such as Rev. Rul. 2006-31.
As noted above, at least 90% of a RIC’s gross income must be derived from the following categories:
- Payments with respect to securities loans;
- Gains from the sale or other disposition of stock or securities or foreign currencies;
- Other income derived with respect to its business of investing in stock, securities or currencies
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) (Subpart F) or Section 1293(a) (personal foreign investment company with a Qualified Electing Fund (QEF) election) 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 which is attributable to the amount included.
In the past, the IRS 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 the business of investing in stocks, securities or currencies. The proposed regulations provided that an inclusion under Section 951(a)(1)(A)(i) or Section 1293(a) cannot be treated as falling within that other income category. As a result, the proposed regulations provided that a Subpart F or QEF inclusion without a corresponding distribution could never be qualifying income for the RIC income test.
The final regulations completely reverse this position by providing that Subpart F inclusions and QEF inclusions, even without corresponding distributions from earnings and profits, are always treated as qualifying income because they are other income derived with respect to its business of investing in stock, securities, or currencies.
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