United States

IRS proposes new RIC regulations and limits future RIC rulings

TAX ALERT  | 

In Prop. Reg. section 1.851-2 and a related revenue procedure (Rev. Proc. 2016-50), the IRS announced several changes to its policies regarding qualifying income for regulated investment companies (RICs). RICs generally include mutual funds, and are required to satisfy an income test under which at least 90 percent of their annual gross income must be derived from specified sources—generally from stocks, securities, currencies, certain derivatives and qualified publicly traded partnerships.   

With Rev. Proc. 2016-50, the IRS permanently stepped back from a previous practice of ruling on whether or not assets constitute ‘securities’ for purposes of the RIC income and asset qualification tests. Prior to July 2011, the IRS had issued rulings addressing whether or not certain financial instruments constitute securities, particularly those that provide exposure to commodities. Such rulings were useful because commodities generally are not qualifying RIC assets. The IRS halted this practice in July 2011 and indicated it would study whether further issuing rulings or guidance on the issue would be appropriate. After further consideration, the IRS determined that it would cease providing rulings on the issue. Since the RIC test borrows the definition of a security from the Investment Company Act of 1940, and the Securities and Exchange Commission (SEC) has jurisdiction over interpreting the 1040 Act, the IRS stated it would defer to the SEC’s views as to this definition of security.

In related guidance, the IRS proposed new regulations to clarify when taxable income inclusions from controlled foreign corporations (CFCs) and qualified electing funds (QEFs) constitute qualifying income for purposes of the RIC gross income test. The proposed regulations provide that these amounts are only qualifying income if they are accompanied by a distribution made out of the earnings and profits of the CFC or QEF, making them dividends.

In the past, the IRS issued private letter rulings holding that CFC and QEF inclusions were qualifying income even if there was no distribution from the CFC or QEF. The preamble to the proposed regulations explicitly rejects the analysis and conclusions of these prior rulings related to taxable income inclusions without distributions.

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