Tax Reform Watch: What the New Tax Law Does and Doesn’t Do for Regulated Investment Companies– January 09, 2018 by Jay Laurila

The Tax Cuts and Jobs Act (TCJA), signed into law on December 22, 2017, makes several changes to existing tax laws that affect Regulated Investment Companies (RICs). The big headline items of TCJA include the reduction of the maximum corporate tax rate from 35% to 21%, the repeal of the corporate alternative minimum tax (AMT), and U.S. corporate taxation’s shift from a worldwide tax system to a territorial tax system. While these wholesale changes to the corporate tax system should not have a significant direct impact RICs, as they will continue to have a 100% deduction for dividends paid to shareholders, all of the mentioned changes will indirectly impact RICs due to their investment in the companies that stand to benefit. In addition, it’s just as important to note the many significant provisions that did not make their way into the new law. 

What Didn’t Happen

Some of the initial discussion items and provisions passed by the different Congressional chambers that would have been the most impactful to RICs did not make the final bill. Accordingly, TCJA’s impact to RICs may be best characterized by what it does NOT include: 

  • Mandatory FIFO. The original Senate version of the bill included a provision to require mandatory use of the first-in, first-out lot selection relief method for all taxpayers, though there may have been an exception granted for RICs.
  • Repeal of private activity bonds. The original House version of the bill included a repeal of the tax-exempt status of private activity bonds.
  • Mandatory “Rothification” of retirement savings. While not in the original House or Senate bills, there was significant discussion leading up to the TCJA on limiting or eliminating the tax-deferred benefit for 401(k) contributions to serve as a revenue raiser.
  • Mark to market on derivatives. Various derivative mark-to-market provisions were considered but not included in the final version of the bill nor in the proposals from each Congressional chamber.
  • Repeal of the net investment income tax. The 3.8% net investment income tax on investment income of certain high-income individuals as part of the Affordable Care Act remains in place. 

What Changed

While no changes were specifically made to RIC taxation (known as subchapter M) or to the RIC excise tax rules, a few new provisions may affect RICs. These rules found below generally apply for tax years beginning after December 31, 2017. 

  • Taxable year of income recognition. TCJA requires taxpayers to include income items in taxable income no later than the year the income item is included for financial statement purposes. This provision may require the current inclusion of market discount accrual where the RIC does not make an election to include market discount in current taxable income, such as in tax-exempt funds. It also may require acceleration of some income where there are differences in classification of an investment instrument, such as a preferred stock classified as debt for book purposes but an equity for tax purposes. According to the conference committee statement, this provision does not require recognition of securities marked to market for financial statement purposes unless otherwise required under tax law, such as IRC Section 1256 contracts for example, or when an allocable share of income is recognized from an investment in partnerships.
  • A new limitation on deductibility of business interest. TCJA limits the deductibility of net business interest to 30% of “adjusted taxable income.” This limitation is applied to net business interest expense, meaning if interest income exceeds interest expense, no limitation is applied. While investment interest expenses are not subject to these limitations, it is unclear if RICs or investment companies structured as corporations are deemed to be engaged in a trade or business for these purposes.
  • Special flow-through tax deduction for partnerships and REITs. The TCJA creates a 20% deduction for qualified pass-through business income. By definition, qualified business income includes dividends from REITs and income from qualified publicly traded partnerships, including ordinary gains on the sale of the partnerships under IRC Section 751. However, as currently drafted, corporations, including RICs, are ineligible for the special pass-through deduction. Furthermore, no provision in TCJA allows a RIC to pass-through this treatment to investors as they can with certain other items such as qualified dividend income and foreign tax credits. Absent any technical corrections or provisions to address this, an investor in a fund investing in REITs or MLPs would pay higher taxes on income from these investments than an investor in a separately managed accounting holding the same investments.
  • Taxation of sales or exchanges of partnership interests by foreign persons. Gain or loss on the sales of partnership interests will be considered effectively “connected income” to the extent the transferor would have had connected gain or loss on the sale of the underlying assets of the partnership. This approach essentially codifies Revenue Ruling 91-32 and applies to transfers of partnership interests on or after November 27, 2017. To facilitate tax collection, TCJA requires U.S. transferees (purchasers) of a partnership interest to withhold 10 percent of the amount realized on the sale or exchange by a foreign person if the gain would be considered effectively connected to the U.S. To the extent the transferee fails to withhold the correct amount, the partnership is required to withhold from distributions to the transferee partner the amount of the required withholding. The IRS has issued Notice 2018-08, which grants a temporary suspension of this requirement for publicly traded partnerships. At the time of this writing, there is no similar relief for transfers of nonpublicly traded partnerships.
  • Repeal of tax-exempt status for advance refunding bonds. A refunding bond is a bond used to pay principal, interest or redemption price of a previously issued bond. Specifically, a municipality may look to retire an old bond by issuing a new bond. Advance refunding bonds are bonds issued more than 90 days before the redemption of a refunded bond. Typically proceeds from the new bond are invested in an escrow account until a future date when the old bond can be redeemed. TCJA repeals the tax-exempt status of the advance refunding bonds for those issued after December 31, 2017. The interest on the original bond remains tax-exempt.
  • Amendment of the insurance business exception to Passive Foreign Investment Company (PFIC) status. RICs that invest in foreign insurance companies will need to classify these companies as PFICs if, along with other requirements, the insurance company would not be taxed as an insurance company in the United States.
  • Alternative minimum tax (AMT) changes. Corporate AMT was repealed. Changes in the AMT rules for individual taxpayers due to increased exemption amounts, higher-income thresholds for phaseout of the AMT exemption, and the limitation on deductibility of state and local taxpayers should dramatically reduce the number of individuals paying AMT. Managers of tax-exempt funds who may have avoided investing in private activity bonds due to investor AMT concerns may reconsider this strategy in light of TCJA.
  • Change of dividends received deduction percentage. The dividends received deduction (DRD) for corporate investors has been reduced from 70% to 50% of the dividend amount. As RICs are eligible to pass through DRD eligible dividends to their corporate shareholders, this change of exclusion rate is important to note.
  • Repeal of miscellaneous itemized deductions. Previously, miscellaneous itemized deductions, including investment management fees of separately managed accounts, were deductible to the extent the total exceeded two percent of an individual’s adjusted gross income — though these deductions were not allowed for AMT purposes. TCJA repealed the deductibility of these expenses for tax years beginning after 2017. Expenses of publicly offered RICs are allowed as a deduction against the investment income of the RIC and may reduce the dividend income of a RIC investor. Accordingly, some taxpayers may end up with a better after-tax return by investing in a RIC versus investing in a separately managed account. 

Every fund will have its own unique tax situation and, accordingly, will feel the impact of TCJA differently. For more information on how TCJA may affect you and your fund, contact Jay Laurila at, Ravi Singh at or Rob Velotta at
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.