Although the Securities and Exchange Commission has provided some relief to regulated investment companies (mutual funds and business development companies) in the wake of the coronavirus pandemic (see Release No. 33817, March 13, 2020, relating to in-person board meeting requirements and Form N-CEN filing requirements; Release No. 33821, March 23, 2020, regarding inter-fund and affiliated company lending; and Release 33837 temporarily easing restrictions on the issuance or sale of senior securities by BDCs), the Internal Revenue Service has yet to do so. As a result, regulated investment companies (RICs) are facing many challenges during these uncertain times.
Most of the tax-related issues are a result of significant and recent market declines and the need for RICs and business development companies (BDCs) to make distributions to meet their tax qualification requirements. Without relief from the IRS, a RIC may need to consider the following issues or remedies:
Tax equalization
As a result of significant redemptions, an open-end RIC may be unable to meet its tax distribution requirements, or, if it did so, the fund’s net asset value would be much lower. The rule is known as the 90% distribution requirement, and necessitates a RIC pay out 90% of its net income to its shareholders before the end of the subsequent tax year.
To put it in greater detail: A RIC will not qualify for treatment under Subchapter M, with respect to a taxable year, unless the RIC's deduction for dividends paid to its shareholders (exclusive of capital gain dividends) at least equals the sum of 90% of the RIC's investment company taxable income (computed without regard to the dividends-paid deduction) plus 90% of the RIC's net tax-exempt income. IRC section 851(a)(1).
As a practical matter, RICs generally attempt to distribute all of their investment company taxable income and capital gains because there would be a tax on the RIC with respect to any undistributed income and gain. A RIC that does not satisfy the distribution requirements in any taxable year will be taxed as a normal corporation.
Normally this isn’t an issue, however in March, as the economic fallout from the coronavirus mounted, investors pulled record-breaking amounts out of stock, bond and mixed-equity and money market mutual funds. It may leave some mutual funds unable to meet the 90% distribution requirement.
Consider this example of a RIC that starts the year with a $100,000 net asset value:
Date |
Net Asset Value |
Undistributed NII/ICTI |
Unrealized gain (loss) |
Realized gain (loss) |
January 1 |
$100,000 |
|
|
|
March 15 |
$80,000 |
$20,000 |
($40,000) |
|
50% Redemption |
(40,000) |
|
|
|
|
$40,000 |
$20,000 |
($20,000) |
($20,000) |
Assume no additional income, inflows, or redemptions for the remainder of the year. Market declines continue. |
||||
December 31 |
$15,000 |
$20,000 |
($45,000) |
($20,000)[i] |
Required distributions (90%) |
|
$18,000 |
|
|
To qualify as a RIC, the fund must distribute at least $18,000, which represents 90% of its investment company taxable income. But the RIC has only $15,000 of net assets left.
Open-end mutual funds, however, are permitted to claim a dividends-paid deduction for the earnings and profits distributed to redeeming shareholders. This is often described as tax equalization.
Date |
Net Asset value |
Undistributed NII/ICTI |
Earnings & Profits |
January 1 |
$100,000 |
|
|
March 15 |
$80,000 |
$20,000 |
$20,000 |
50% Redemption |
(40,000) |
(10,000) |
(10,000) |
|
$40,000 |
$10,000 |
$10,000 |
December 31 |
$15,000 |
$10,000 |
$10,000 |
Dividends Paid |
(10,000) |
(10,000) |
(10,000) |
|
$5,000 |
NONE |
NONE |
Although the ability to claim the tax equalization deduction is not an issue, the calculation methodology is unclear. RICs should consult with their tax advisers if they plan to use this redemption-related deduction.
Closed-end funds and business development companies usually do not have sufficient redemptions for them to have much benefit from tax equalization.
While tax equalization may offer a remedy to some RICs, there are other issues to consider amid the economic fallout from the coronavirus:
Significant unrealized losses may create leverage ratio issues
Although BDCs may leverage their assets up to a 2:1 ratio, most BDC leverage ratios are significantly less – or at least they were before the market declined in March. The need to make significant dividend distributions this year will only exacerbate this leverage problem.
Capital restructuring and debt modifications
The financial stress suffered by issuers of the securities held by a RIC may trigger an increased level of payments-in-kind and debt modifications that can result in significant non-cash income for the RIC. This can exacerbate what may already be a liquidity issue at the fund level, since this income must be distributed for the RIC to meet its tax qualification requirements.
Use of dividend reinvestment plans (DRIPs) to minimize cash outflows
Dividend reinvestment programs give shareholders the option of reinvesting the amount of a declared dividend into additional shares issued by the fund. Although no cash is actually paid to shareholders, the distribution is treated as if a cash dividend were paid and the cash was then used to purchase the additional shares. As a result, a RIC may claim the deemed cash dividend as a dividends paid deduction and the shareholders report the same amount as taxable dividends.
Election by the shareholder to receive stock or cash dividends
Most RICs that do not have formal dividend reinvestment plans provide that shareholders have the election to receive stock or cash when dividends are paid. Usually the RIC considers the default shareholder election to be the receipt of stock unless the shareholder specifically opts out. Although this arrangement significantly reduces the amount of cash needed to meet a RIC’s distribution requirements, the amount of cash required remains uncertain until the opt-out period expires.
Part cash/part stock declared dividend
A RIC may declare a part cash/part stock distribution limiting the amount of cash that will be paid.
Pursuant to Revenue Procedure 2017-45, 2017-35 IRB, 08/11/2017, a part cash/part stock declared distribution will qualify for the fund’s dividends paid deduction only if all of the following conditions are met:
- A publicly offered RIC makes a distribution to its shareholders with respect to its stock.
- Pursuant to the declaration of the distribution, each shareholder has a cash-or-stock election with respect to part or all of the distribution.
- The maximum aggregate amount of cash to be distributed to all shareholders is limited by the declaration of the distribution as a percentage of the total distributed is not less than 20%
- Every shareholder who has elected less than the total cash percentage receives his or her elected amount.
- If the aggregate of all shareholders' elected cash amounts does not exceed the maximum declared cash amount, every shareholder receives his or her elected amount.
- If the aggregate of all shareholders' elected cash amounts exceeds the maximum declared cash amount, then each shareholder electing excess cash receives a specified ratio of the available cash.
UPDATE: Revenue Procedure 2020-19, which will be published in IRB 2020-22, dated May 26, 2020 temporarily modifies Rev. Proc. 2017-45 solely with respect to distributions declared on or after April 1, 2020, and on or before Dec. 31, 2020 reducing the minimum amount of cash that shareholders may receive to not less than 10% of the total declared distribution.
Retained capital gains
A RIC may elect conduit treatment with respect to its undistributed long-term capital gains. If a RIC makes such an election, the RIC pays tax on the undistributed gains and also treats such undistributed gains as if they were distributed to its shareholders at the end of the RIC's taxable year. The shareholders must include their share of the undistributed gains in their income but they also receive credit for the taxes paid by the RIC with respect to such gains and they also may increase the basis of their shares in the RIC by their shares of the after-tax amount retained by the RIC.
CARES Act
Business development companies and other RICs that may qualify for financial support under the CARES Act should be very careful that their participation does not restrict their ability to pay dividends required to meet the RIC’s tax qualification requirements.
Tax return matters
Notice 2020-18, as updated, delayed the filing of tax returns due prior to July 15, 2020 until July 15, 2020.
RICs are not permitted to e-file Form 1120-RIC, U.S. Income Tax Return for Regulated Investment Companies. As a result, these returns must be hand-signed by an authorized officer thereby causing much hardship during the stay-at-home requirements in place in most states. Industry representatives recently asked the IRS to permit taxpayers to electronically sign these returns but the IRS has not yet responded.
[i] Although the fund realized $20,000 in capital losses, the capital losses do not reduce the fund’s investment company taxable income nor its distribution requirements. The capital losses are carried forward to subsequent tax years.
