The Department of Treasury and the IRS have issued final regulations related to Regulated Investment Company (RIC) qualification testing for RICs invested in foreign corporations treated for U.S. federal income tax purposes as controlled foreign corporations (CFCs) or passive foreign investment companies (PFICs). The final regulations are an about-face from the original IRS position in proposed regulations released in September 2016. The final rule, effective March 19, 2019, allows a RIC invested in CFCs and PFICs to treat the required CFC inclusion or PFIC inclusion (for Qualified Electing Funds, or QEFs), respectively, as qualifying income for purposes of a RIC’s gross income test.
How the 2016 Proposed Regulations Addressed Gross Income Testing
For U.S. tax purposes, a CFC is defined as a foreign corporation where more than 50% of the total combined voting power of all classes of stock of the corporation or the total value of the corporation are owned by U.S. shareholders, including RICs, during any day of the foreign corporation’s taxable year. A RIC will commonly own a CFC to gain exposure to investments that may not ordinarily meet a RIC’s income and diversification requirements if held directly by a RIC. A RIC is allowed to invest up to 25% of its total assets in any one corporation, including a CFC, and is limited to investing up to 25% of its total assets in corporations it controls. U.S. shareholders of CFCs are required to include their pro rata share of taxable income from the CFC, known as a subpart F inclusion, in their gross income on the last day of the CFC’s taxable year.
A PFIC is a foreign corporation where at least 75% of the corporation’s gross income is from passive sources or at least 50% of the corporation’s assets produce passive income. Typically a RIC will make a mark-to-market election with respect to its investments in a PFIC. Alternatively, a RIC is also allowed to make a QEF election. In the latter case, the RIC includes in its taxable income its pro rata share of ordinary income and net capital gain from the PFIC. A RIC is subject to the same 25% of total assets limitation with respect to investments in PFICs.
The proposed regulations from 2016 required the CFC (or PFIC) to make a distribution to the RIC in the amount of the subpart F inclusion (or QEF inclusion) for that amount to constitute “other income,” which qualifies for purposes of the RIC’s 90% gross income test. If the distribution was not made, the proposed regulations treated the required inclusion as non-qualifying income to the RIC, which if greater than 10% of a RIC’s gross income (combined with other non-qualifying income) would cause a failure in the RIC’s qualification tests and subject the RIC to corporate tax.
The New and Final Rule for RICs Invested in CFCs and PFICs Regarding the Gross Income Test
Treasury and the IRS received several comments on the proposed regulations. All of them recommended they reconsider the requirement that a distribution be made from the CFC (or PFIC) to the RIC for the required inclusion to qualify as “other income” for purposes of the 90% test. The commentators noted that requiring a cash distribution could create unintended consequences for the RIC, especially in a situation where the RIC may not have full control of the timing of any distributions made from the CFC (or PFIC). As a result, Treasury and the IRS issued final regulations providing that as long as the required inclusion is derived with respect to the RIC’s business of investing in stocks, securities or currencies, the amount will be treated as “other income” and, thus, would be qualifying income for purposes of the RIC’s 90% gross income requirement. A RIC investing in CFCs (or PFICs) will no longer need to plan for distributions from the CFC (or PFIC) to be assured the required inclusions will be treated as qualifying income to the RIC.
Additional IRS Comments on Qualification for RICs with Derivative Contracts
Treasury and the IRS also received comments on the IRS process to issue a ruling on whether a financial instrument or position meets the definition of a security under the Investment Company Act of 1940. The IRS stopped issuing these rulings to RICs in 2016, ending the practice of providing certainty to a RIC on whether or not a particular financial instrument or position would be treated as a security (and thus income from the security is qualifying income to the RIC). The IRS affirmed they will continue the practice of not issuing rulings or determinations in this regard.
Related to this, the IRS also received comments on two revenue rulings issued in 2006 on whether or not derivative contracts would be treated as securities. The rulings clarified that certain types of derivative contracts could meet the definition of a security for purposes of a RIC’s qualification tests, while others may not. The IRS had considered withdrawing these rulings, but decided not to withdraw after comments received by the IRS suggested that doing so would create confusion and uncertainty with respect to investments in derivative contracts by a RIC.
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