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.

Conclusion

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.

Footnotes

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
Morrison & Foerster LLP
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Morrison & Foerster LLP
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions