United States: IRS Issues New "No Rule" Area And Related Proposed Regulations: Potential Implications For Regulated Investment Companies

On September 27, 2016, the Internal Revenue Service (the "IRS") issued proposed regulations under Section 851 of the Internal Revenue Code of 1986, as amended (the "Code") (the "Proposed Regulations") and a related Revenue Procedure impacting the ability of regulated investment companies ("RICs") (particularly, RICs seeking to generate commodity market exposure) to satisfy the gross income and asset diversification tests for RIC status under the Code.

As discussed in this Stroock Special Bulletin, the Revenue Procedure establishes a new "no rule" area that impacts the definition of "security" for purposes of the RIC qualification tests under Subchapter M of the Code. This Stroock Special Bulletin further discusses the Proposed Regulations that, among other things, will have the effect of requiring certain foreign entities in which a RIC invests (including offshore commodity investment subsidiaries) to make current distributions to match the RIC's income inclusions in respect of those foreign entities.

Definition of "Security" and New "No-Rule" Area Under Revenue Procedure 2016-50

By way of background, to maintain its RIC status for federal income tax purposes, a RIC must, among other things, derive in each taxable year at least 90% of its gross income from certain enumerated sources (the "gross income test"), including (i) dividends and interest, (ii) gains from the sale or other disposition of stocks, "securities" or foreign currencies, and (iii) other income (including but not limited to gains from options, futures or forward contracts) derived with respect to its business of investing in such stocks, "securities" or currencies (such other income, "Other Income"). Excluded from the list of enumerated sources of qualifying income are income and gains from commodities. In addition, a RIC must diversify its holdings so that, at the end of each quarter of the taxable year, its holdings of "securities" and certain other assets satisfy certain prescribed percentage tests (the "asset diversification test").

The statutory language in the Code setting forth the gross income test specifically provides that the term "security" as used therein is "as defined in section 2(a)(36) of the Investment Company Act of 1940, as amended" (the "1940 Act"). In addition, the relevant Code provisions provide that, for purposes of the asset diversification test, any terms that are not otherwise defined in the applicable Code provisions "shall have the meaning as when used in the [1940 Act]." Because the term "security" is not specifically defined in the context of the asset diversification test, it is therefore defined, for such purpose, by reference to the applicable 1940 Act definition/use. It follows, and the Preamble to the Proposed Regulations so states, that an asset is a "security" for purposes of the gross income and asset diversification tests if it is a "security" under the 1940 Act.

Although it is clear that the term "security" is defined by reference to the 1940 Act definition, it has not always been clear as to how the term should be construed in the absence of specific interpretive guidance from the U.S. Securities and Exchange Commission (the "SEC"). The IRS historically has taken the view that, in the absence of SEC guidance, it could independently construe the meaning of applicable 1940 Act definitions, taking into account the purposes for which those terms are being applied in the context of the applicable RIC provisions of the Code. Given the different policies and goals underlying the Code's RIC provisions and the 1940 Act, it is generally thought that the IRS has more of an incentive to construe the term "security" more narrowly than the SEC.

In 2006, the IRS ruled (in Revenue Ruling 2006-1) that certain derivative swap contracts that provided total return exposure to a commodity index were not "securities" for purposes of the gross income test. In Revenue Ruling 2006-31, the IRS clarified that its holding in Revenue Ruling 2006-1 was limited to the specific derivative contracts described in that ruling and that the ruling "was not intended to preclude a conclusion that the income from certain instruments (such as certain structured notes) that create a commodity exposure for the holder is qualifying income" under the gross income test.

Between 2006 and 2011, the IRS issued numerous private letter rulings concluding that income from various commodity-linked notes (which based on the representations in those rulings generally had characteristics of hybrid securities that were "predominantly securities") could be treated favorably for purposes of the gross income test, with treatment akin to that of income from securities. Then, in 2011, the IRS suspended the issuance of any further private letter rulings addressing the treatment of commodity-related investments by RICs, while the IRS reviewed the issues and considered guidance of broader applicability.

Contemporaneously with the publication of the Proposed Regulations, the IRS issued Revenue Procedure 2016-50 which establishes a new "no-rule" area to the effect that the IRS ordinarily will not issue rulings or determination letters on any issue relating to the treatment of an entity as a RIC that requires a determination of whether a financial instrument or position is a "security" under the 1940 Act. In the Preamble to the Proposed Regulations, the IRS explained that the SEC has exclusive rulemaking authority under the 1940 Act and "[a]ny future guidance regarding whether particular financial instruments, including investments that provide RICs with commodity exposure, are securities for purposes of the 1940 Act is therefore within the jurisdiction of the SEC." Accordingly, if a RIC holds an asset or position that is a "security" under the 1940 Act (determined without regard to tax considerations), including potentially an asset or position that produces commodity exposure, such asset or position will be a "security" for purposes of the gross income test and the asset diversification test.

The status of the IRS's previously issued guidance remains to be seen. The IRS has requested comments as to whether Revenue Ruling 2006-1, Revenue Ruling 2006-31, and other previously issued guidance that involves determinations of whether a financial instrument or position held by a RIC is a "security" under the 1940 Act, should be withdrawn effective as of the finalization of the Proposed Regulations. Accordingly, it is unclear whether RICs that have relied on the principles espoused in Revenue Ruling 2006-31 and in the various private letter rulings related to the "security" status of commodity-linked notes (or other instruments or positions) can continue to rely on such guidance, and the scope of instruments and positions, including derivatives, that will be treated as "securities" for purposes of the gross income test and the asset diversification test will need to be re-examined, with particular focus on their "security" status under the 1940 Act. It is possible that the effective ceding of jurisdiction by the IRS to the SEC in respect of "security" status determinations will, in certain cases, broaden the scope of permissible RIC investments (including, potentially, commodity-related investments).

As the term "security" is not the only term that is determined by reference to the 1940 Act in the context of the RIC provisions of the Code, and security status under the 1940 Act may also be relevant in tax contexts other than the determination of an entity's status as a RIC, it remains to be seen whether the IRS will apply a no-rule policy in the context of such other 1940 Act defined terms or non-RIC contexts.

Required Distributions by Foreign Corporate Investments

If a RIC forms a wholly-owned subsidiary under the laws of a foreign jurisdiction through which it conducts an investment program, including in respect of commodities or commodity-linked instruments, including derivatives, that subsidiary will be classified as a controlled foreign corporation (a "CFC") for federal income tax purposes.1 As a result of the subsidiary's classification as a CFC, the RIC will be required to take into account, on a current basis, certain items of income earned by the subsidiary, including dividends, interest, certain other passive income, and certain gains from transactions in commodities. The RIC will be required to include these items in income ("CFC Inclusions"), whether or not the subsidiary actually distributes this income to the RIC.

Similarly, if a RIC makes a portfolio investment in an offshore investment fund or an offshore feeder vehicle for an investment fund that effects transactions in securities and/or commodities, the offshore investment fund or feeder vehicle likely will be classified as a "passive foreign investment company" (a "PFIC") for federal income tax purposes.2 To avoid the very unfavorable tax results typically associated with an investment in a PFIC, the RIC may, in certain cases, either (x) elect to mark-to-market its investment in the offshore entity3 or (y) elect to treat the offshore entity as a "qualified electing fund" ("QEF"). In the latter case, the RIC must include in its income its share of the QEF's income and gains ("QEF Inclusions"), whether or not such income is distributed from the QEF to the RIC.

The flush language to Section 851(b) of the Code treats CFC Inclusions and QEF Inclusions that are currently distributed by the CFC or QEF to the RIC as dividends, and, thus, as qualifying income for purposes of the gross income test. The IRS, however, has issued numerous rulings that, even in the absence of corresponding distributions, CFC Inclusions and QEF Inclusions constitute Other Income, and, thus, qualifying income, on the ground that CFC Inclusions and QEF Inclusions are derived by the RIC from its business of investing in the stock of the CFC or QEF.

Assuming the Proposed Regulations are adopted as final regulations in their current form, CFC Inclusions and QEF Inclusions will constitute qualifying income for purposes of the gross income test only if they are accompanied by corresponding current distributions in accordance with the flush language of Section 851(b) cited above (and, correspondingly, CFC Inclusions and QEF Inclusions that are unaccompanied by such distributions will not constitute qualifying Other Income).

In the Preamble to the Proposed Regulations, the IRS specifically renounces the reasoning and conclusions of any previously issued private letter rulings that treated CFC Inclusions and QEF Inclusions, in the absence of current distributions, as qualifying Other Income. Accordingly, notwithstanding the prospective effective date of the Proposed Regulations, there can be no assurance that CFC Inclusions and QEF Inclusions that are unaccompanied by corresponding distributions constitute qualifying income at the current time. RICs would be advised to cause any CFCs (in particular any offshore subsidiaries that are used primarily to invest in commodities and/or commodity-linked instruments, including derivatives) to, or, where possible, obtain assurances that any QEFs in which they have invested will, make current distributions so that the applicable CFC Inclusions and QEF Inclusions can qualify as "dividend" income (and thus qualifying income) under the flush language of Section 851(b) and applicable Treasury regulations (without having to rely on the potential Other Income treatment of such income). In other cases, RICs may need to consider utilizing mark-to-market elections in respect of the PFICs in which they invest (rather than QEF elections) so as to avoid the potential distribution requirements in respect of QEF Inclusions. RICs that were direct recipients of the previously issued private letter rulings should consult their advisors regarding the extent to which they may continue relying on those rulings (including the effect that the finalization of the Proposed Regulations would have on those rulings).

The IRS and the Treasury Department requested comments on the Proposed Regulations by December 27, 2016. The Proposed Regulations, if finalized in their current form, would be effective for taxable years that begin on or after the date that is 90 days after the date such regulations are finalized.


Both the Proposed Regulations and the contemporaneously issued Revenue Procedure 2016-50 represent a significant change in direction by the IRS in relation to the interpretation of the term "security," and the treatment of CFC Inclusions and QEF Inclusions that are unaccompanied by current cash distributions, in the context of the RIC qualification tests. In light of these new developments, all RICs should consult both their 1940 Act attorneys and tax attorneys to understand the scope of permissible investments and how best to protect their RIC status.


1 Generally speaking, a foreign corporation is a CFC if more than 50% of the voting stock or 50% of the value of the stock of the corporation is owned by United States persons that each, directly, indirectly or constructively, own 10% or more of the voting stock of the corporation.

2 Generally speaking, a foreign corporation is a PFIC if 75% or more of its income for the taxable year is passive income, or the average percentage of its assets during the taxable year that produce passive income, or that are held for the production of passive income, is at least 50%, all as determined under prescribed rules.

3 If the RIC makes the mark-to-market election in respect of a PFIC, the RIC generally would recognize as ordinary income any increase in the value of its interest in the PFIC for the relevant taxable year, and as ordinary loss any decrease in such value for the relevant taxable year with certain limitations.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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