IRS issues guidance for BDCs and Mutual Funds
INSIGHT ARTICLE |
The IRS recently issued guidance (Revenue Procedure 2017-45, 2017-35 IRB, 08/11/2017, IRC Sec(s). 305) regarding the treatment of part cash/part stock distributions of regulated investment companies (“RICs”) and real estate investment trusts (“REITs”) for purposes of the RIC and REIT distribution requirements. RICs and REITs contemplating such distributions should be aware that the Revenue Procedure is effective for part cash/part stock distributions declared on or after August 11, 2017.
The Revenue Procedure is intended to deal with situations where the amount of cash payable to shareholders is limited by declaration, thereby requiring all shareholders to receive part cash/part stock if the total cash limitation is oversubscribed.
- Part cash/part stock distributions will NOT qualify for the dividends paid deduction if, among other requirements, cash limitation amounts are insufficient or if cash allocations among shareholders is not as prescribed.
- This can result in the fund’s disqualification as a RIC for the taxable year.
- The Revenue Procedure should not have a significant impact on many BDC and mutual funds since most have adopted dividend reimbursement plans (DRIP) and, therefore, do not declare part cash/part stock dividends.[i]
Pursuant to the Revenue Procedure, a part cash/part stock declared distribution will only qualify for the fund’s dividends paid deduction if all of the following conditions are met:
- A Publicly Offered REIT or 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 existence of a Cash-or-Stock Election does not affect the federal income tax treatment of the portion, if any, of the declared dividend that is not subject to the election.
- 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 percent.
- Every shareholder that has elected less than the total cash percentage receives his/her elected amount.
- If the aggregate of all shareholders' elected cash amounts does not exceed the maximum declared cash amount, every shareholder receives his/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.
- The calculation of the number of shares to be received by a shareholder is determined based upon a formula that
(1) utilizes the market price of the shares;
(2) is designed so that the value of the number of shares to be received in lieu of cash with respect to a share corresponds as closely as practicable to the amount of cash to be received under the declaration with respect to that share; and
(3) uses data from a period of no more than two weeks ending as close as practicable to the payment date.
The fund directors declared a distribution of which no more than 25% of the total distribution may be made in cash; the remainder being paid in fund shares.
Total distribution: $0.05 per share/$20,000
Total shares outstanding 400,000 shares
Shareholders requesting 10% cash: 300,000 shares
Shareholders requesting 50% cash: 100,000 shares
Cash Limitation Amount $5,000
Cash Limitation Percentage ($5,000/$20,000) 25%
Cash requested at 10% $1,500
Cash requested at 50% $2,500
Total cash requested $4,000
Since the total cash amount is less than the declared limit, all shareholders will receive their requested cash/stock amounts. The distribution qualifies for the Dividends Paid Deduction.
Same as Example 1 except:
Shareholders requesting 10% cash: 100,000 shares
Shareholders requesting 50% cash: 300,000 shares
Cash requested at 10% $500
Cash requested at 50% $7,500
Total cash requested $8,000
Cash Limitation $5,000
In order to maintain deductibility of the distribution for RIC qualification purposes, the Revenue Procedure requires the follow allocation of cash to shareholders:
Shareholders requesting 10% $500 ($0.005/sh)
Shareholders requesting 50% $4,500 ($0.015/sh)
The fund directors declared a distribution of which no more than 15% of the total distribution may be made in cash; the remainder being paid in fund shares.
The distribution will not qualify for the RIC’s dividends paid deduction since the cash limitation is less than 20%.
[i] In a typical DRIP:
- shareholders automatically “opt-in” to reinvest cash dividends in additional fund shares
- shareholders may chose NOT to participate in whole or part in the DRIP plan
- all of the fund dividends are declared as cash dividends
- shareholders opting for additional shares are treated as if they received taxable cash dividends and immediately purchased additional shares with the deemed cash receipts