United States

Regulated Investment Company Modernization Act of 2010

INSIGHT ARTICLE  | 

On Dec. 22, 2010, President Obama signed into law the Regulated Investment Company (RIC) Modernization Act of 2010 ("the Act"). The mutual fund industry worked for many years to have these provisions enacted, primarily because Subchapter M of the Internal Revenue Code, which was enacted almost 70 years earlier and not significantly modified since the Tax Reform Act of 1986, did not convey adequately how a more mature and sophisticated mutual fund industry should be taxed.

The complexity of financial markets, the specialization of investment products, and the intricacies of investment vehicles coupled with the need to comply with complex tax rules elsewhere in the Code (loss deferrals, foreign exchange gains and losses, utilization of pre-acquisition capital loss carryforwards, et al), significantly increased the potential for a costly disqualification of a fund.

The Act also provides many long sought-after improvements addressing procedural issues that are no longer applicable.

Curative procedures

Traditionally, one of the major problems with both asset diversification requirements in Subchapter M has been that a RIC cannot know until after the end of the quarter or the end of its fiscal year, whether it inadvertently failed either test. Pre-existing rules include a curative provision if the failure to comply is addressed within 30 days of the close of the failed quarter.

Likewise a fund must meet qualifying source of income test that may not be determinable until the tax year has closed or may change due to post-year reporting by income sources for corporate actions, returns of capital, etc. al. No such curative ability previously existed for the qualifying income test.

Failure to meet any of these tests could result in the fund's disqualification as a regulated investment company thereby subjecting it to the Federal corporate income tax. A fund could avoid the tax, but pay stiff penalties, but only if the IRS discovered the failure.

The Act allows for a six-month cure provision for the certain de minimis failures of the asset diversification tests and for failures due to reasonable cause. It also provides a cure for inadvertent failures to comply with the qualifying income test by making appropriate disclosures and by paying a penalty.

Changes to Rules Regarding Distributions

  • One of the more significant disconnects between the mutual fund industry and Subchapter M is that the tax law considers the different distribution classes of fund shares (e.g., A, B, C, and Institutional shares) as a single share class.

Since distribution expenses are allocated differently to these fund share classes, a RIC is subject to disqualification if the resultant unequal dividends paid to shareholders are deemed by the IRS to be preferential to one or more of those shareholder groups. This is because preferential dividends do not qualify for the RIC's dividends paid deduction thereby potentially triggering failure as a RIC or tax on the resulting amount of investment company taxable income deemed undistributed.

The RIC Modernization Act repeals the preferential dividend rule for publically offered funds. RICs not qualifying as publically traded for this purpose are still subject to the traditional preferential dividend rule and risks.

  • Under prior law, a RIC was required to send written notification of any dividend character designation to its shareholders within 60 days of the fund's year end. Typically a mutual fund would meet this notification requirement by including a footnote or notation within its annual report. These designations would include the tax treatment of various distributions made through the course of the fund's taxable year, but would not provide sufficient detail for a shareholder to determine the tax treatment applicable to the distributions he/she received.

The Act, therefore, eliminates this 60-day notice requirement and permits the reporting of capital gain dividends, exempt interest dividends, foreign tax credits, qualified dividend income, dividend received deductions and credits for tax credit to shareholders on Form 1099; a more practical and efficient solution.

  • Related to the above is the ability to pass through the characterization of dividends from fund of funds. Previously, if a RIC was invested in other mutual funds, the ability to pass through tax exempt interest or foreign taxes it received from those funds was lost. RICs are now permitted to pass through these attributes to their underlying shareholders.
  • As is the case with all corporations making distributions to shareholders during their current taxable year, a RIC was required to assume there would be sufficient current year earnings and profits to cause those distributions to be taxable dividends to shareholders. If it was later determined that the some of the distributions should have been considered returns of capital, all distributions during the taxable year would need to be reclassified proportionately.

When any of those revised distributions were made in a prior calendar year, the RIC would need to amend its prior year Forms 1099 thereby potentially requiring its shareholders to file amended income tax returns. The Act eliminates this RIC and shareholder compliance burden by requiring the adjustments be applied only to those distributions in the current calendar year.

  • Under previous law, earnings and profits calculation rules would cause some or all returns of capital distributions made by a RIC invested exclusively in tax exempt securities to be taxable dividends. The Act eliminates this inequity by permitting certain deductions associated with tax exempt income to be taken into account when calculating current earning and profits.
  • Because of ambiguity in the previous law, it was often difficult for a fund to determine whether a distribution in partial redemption of stock should be treated as a taxable exchange or as a dividend distribution. The Act eliminates the uncertainty and allows for publically offered open-end RICs to treat distributions in redemption of stock as exchanges.
  • Under prior legislation, a RIC that suffered losses after December 31or capital losses after October 31 that reduced its fiscal year taxable income, net capital gains or current earning and profits, might need to amend previously reported Forms 1099. The Act remedies this by permitting a RIC to elect to treat a post-December 31 loss or post-October 31 capital loss as arising on the first day of the fund's next taxable year.
  • In order for the Act to be revenue neutral, the amount of capital gain net income required to be distributed during a calendar year to avoid a 4% excise has increased from 98% to 98.2%

Capital Loss Carryforward Provisions

Previously, a fund was permitted the ability to carry forward losses for up to eight years. All capital loss carryforwards were considered short term capital losses even those that originally were characterized as long-term when realized. The Act changes this rule to better match the capital loss carryforward rules applicable to, individuals, that is, a RIC is now permitted unlimited carryforwards of net capital losses, and the losses retain their original short and long term designations.

Repeal of penalty with respect to deficiency dividends

Under prior law, as a penalty for making a deficiency dividend, a RIC was subject to an interest charge as well as a potential additional penalty that could have resulted in a rate as high as one-half of the amount of the dividend itself. A RIC that has an adjustment to its investment company taxable income, undistributed net capital gain or deduction for dividends paid, under current law, may now pay a deficiency dividend in a later year in order to avoid being subject to RIC level tax on the increased amount of its investment company taxable income, or net capital gain which has not yet been distributed to its shareholders.

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