Tax Quarry

 Under the Regulated Investment Company Modernization Act (2009), the government is attempting to modernize the rules governing the tax treatment of regulated investment companies (RIC).  What is an RIC?  Well, these vehicles provide the average investor with the ability to invest in a diversified pool of professional managed investments.  

Below is a summary of a few of the changes expected to come into effect soon:

Capital Loss Carryovers: 

After the changes the capital loss carry-forward rules for RIC will be changed to match the rules governing individuals investing directly in securities.  Essentially, this means that RICs would have unlimited carry-forwards of the net capital losses. 

Modification of Gross Income and Asset Tests: 

The income and asset modification has been significantly updated.

 First, commodities will be included in the list of enumerated sources from which RICs must earn 90% of their income.  Accordingly, going forward shareholders will be able to access commodity investments through mutual funds. 

Second, where there is a breach of the income test, which requires an RIC to earn 90% of its income from certain enumerated investments, an RIC will be able to pay tax on the excess amount of the breach without losing its status. 

Third, RICs will be eligible to take advantage of the same saving provisions under the tax code, when the RIC fails to satisfy the gross income test, which requires certain asset diversification.  Under the REIT asset test, for non- de minimis the entity must pay an excise tax on only the bad assets if the breach was due to a reasonable cause, the IRS is notified and the assets are disposed of.   For de minimis breaches, if cured within six months the entity will be deemed to be in compliance. 

Modification Rules Related to Dividends and Other Distributions:

Some of the new rules that you will see as a result of the bill are:

(a)          written notice of the tax treatment of various distributions made by the RIC is no longer required at the end of the RIC tax year;

(b)          excess amount of specially-designated dividends, including capital gains dividends (made prior to December 31^st by an RIC with a year end other than a calendar year end) can be reduced before filing an amended tax return;

(c)           certain disallowed deductions associated with tax-exempt income will be taken into account in calculating earnings and profits used to determine taxable income; 

(d)          pass-through of exempt interest dividends and foreign tax credits in fund-of-funds structure will be permitted without regard to the requirement that more than fifty percent of the RIC’s assets are comprised of municipal bonds or stock and securities issued by foreign corporations;

(e)          when computing the RIC’s dividend paid deduction for a taxable year, a spillover dividend can be made with the first dividend payment of the same type of dividend and it must be paid within nine months after the taxable year;

(f)           earnings and profits shall be allocated first to distributions made prior to December 31 and then to distributions occurring after December 31 instead of requiring earnings and profits be allocated pro-rata over all distributions during the taxable year;

(g)          publicly traded RICs with shares that are redeemable upon demand may treat distributions in redemption of stock as exchange of fund shares;

(h)          loss deferral rule for redemptions[1] of stock in fund-of-funds structure does not apply to redemption of stock of a RIC if the redemption is upon the demand of a shareholder which is another RIC;

(i)            repeal of rule, as it applies to publicly offered RICS, disallowing a deduction for a preferential dividends paid to shareholders;

(j)            election available to treat a post-December 31 loss (otherwise known as a late-year loss) as arising on the first day of the funds next taxable year

Modification Rules Related to Excise Taxes

There are three main changes to make note of: 

(a)          excise tax exemption extended to RICs that are owned by pension and retirement plans that are not subject to tax on RIC distributions;

(b)          rules expanded to allow all ordinary gains or losses from the sale, exchange, or other disposition of property, including foreign currency gains and losses, to be considered as derived on the first day of the following calendar year where income was derived after October 31. 

(c)           Estimated tax payments may now be taken into account for purposes of the annual excise tax

Other Provisions to Note

• Repeal of assessable penalty with respect to liability for tax; and
• Modification of sales load basis deferral rule

See H.R. 4337 for more details. 

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Written by Marsha Henry