The Senate passed by unanimous consent bi-partisan legislation modifying and updating federal tax code provisions pertaining to investment companies in order to make them better conform to, and interact with, other aspects of the tax code and applicable securities laws. The Regulated Investment Company Modernization Act, HR 4337, would reduce the burden arising from amended year-end tax information statements, improve a mutual fund's ability to meet its distribution requirements, create remedies for inadvertent mutual find qualification failures, improve the tax treatment of investing in a fund-of-funds structure, and update the tax treatment of fund capital losses. The House passed the legislation by a voice vote in September. Because the Senate passed the legislation with an amendment (the Bingaman Amendment), HR 4337 must return to the House where it is on the calendar to be considered this week. If the House approves the Senate version, the legislation will go to the President, who is expected to sign it.
An SEC-regulated investment company must derive 90 percent of its gross income for a taxable year from certain types of income, called qualifying income, which includes gains from the sale or other disposition of stock or securities. The amendment offered by Senator Jeff Bingaman (D-NM), and approved by the Senate, stripped out a provision in the House-passed bill that would have changed the qualifying income test to provide that gains from the sale or other disposition of commodities are qualifying income for purposes of the gross income test. As a result, income earned by an investment company from derivative contracts with respect to commodity indices would have been qualifying income. If the House can live without this provision, the legislation will go to the President.
The legislation passed by the House and Senate would modernize federal tax code provisions governing mutual funds that have not been updated in any meaningful or comprehensive way since the adoption of the Internal Revenue Code of 1986, and some of the provisions date back more than 60 years. Numerous developments during the past two decades, including the development of new fund structures and distribution channels, have placed considerable stress on the current tax code sections.
In general, regulated investment companies under the Code are domestic corporation that either meet are excepted from SEC registration requirements under the Investment Company Act, that derive at least 90 percent of their ordinary income from passive investment income, and that have a portfolio of investments that meet certain diversification requirements. Regulated investment companies under the Code can be either open-end companies (mutual funds) or closed-end companies.
The legislation would update the capital loss carryforward rules for regulated investment companies so that they match the capital loss carryforward rules for individuals. As a result, an investment company would be permitted unlimited carryforwards of their net capital losses under the HR 4337 and a net long term capital loss will retain its character when carried forward instead of being treated as a short term capital loss as under present law. The legislation would also include commodities as a source of good income. Currently, an investment company must derive at least ninety percent of its income from sources of good income, such as dividends, interest, and gains from the sale or other disposition of stock; and commodities are not one of these enumerated sources.
Further, it a fund currently fails to comply with the ninety percent ``good income’’ requirement by even one dollar it is subject to tax as a corporation at a thirty-five percent rate. The legislation would permit an investment company to cure inadvertent failures to comply with the gross income test by paying a tax equal to the amount by which the company failed the gross income test.
An investment company must also satisfy asset diversification tests under the tax code. . Similar requirements apply to real estate investment trusts (REITs). Unlike investment companies, however, REITs have statutory means to remedy inadvertent failures of such tests. For example, if a REIT fails the asset tests by a de minimis amount and the REIT comes into compliance within six months after it identifies the failure, then the REIT is treated as satisfying the asset tests. For non-de minimis asset test failures, a REIT can avoid disqualification under subchapter M if the failure is due to reasonable cause and not willful neglect and the REIT notifies the IRS, disposes of the assets, and pays an excise tax equal to the greater of $50,000 or the highest corporate tax rate times the net income from the bad assets during the period of failure. The legislation would extend these REIT remedies to investment companies.
Under current law, investment companies are required to send a written designation notice to shareholders within sixty days of the end of their taxable year notifying the shareholders of the tax treatment of various distributions made during the course of the year. Since, this requirement predates the comprehensive Form 1099 information reporting requirements that are also imposed on investment companies, HR 4337 would eliminate the now-obsolete 60-day shareholder notification requirement.
Investment companies may distribute their net capital gain income, determined at the end of their taxable year, through specially-designated capital gain dividends. Investment companies with a taxable year other than the calendar year have to determine whether a dividend made prior to December 31 is a capital gain dividend when it sends information returns (Form 1099) to its shareholders. However, the amount that a RIC expects to be a capital gain dividend at the end of the calendar year may be different from the amount that ultimately is allowed to be treated as a capital gain dividend at the end of the taxable year.
If this occurs, the RIC must send out amended Form 1099s and shareholders must file amended returns clarifying that the dividend was not, in fact, a capital gain dividend. This can be both confusing and burdensome for taxpayers. Rather than force funds and taxpayers to file amended returns for the prior calendar year, the bill would allow the fund to first reduce capital gain dividends in the subsequent calendar year by the amount of the excess capital gain dividends reported in the prior calendar year. Similar rules would apply to other types of specially-designated dividends (e.g., exempt-interest dividends, short-term capital gain dividends and interest-related dividends).
The Code mandates that the current earnings and profits of a regulated investment company are not reduced by any amount which is not allowable as a deduction in computing its taxable income works an inappropriate result for tax-exempt bond funds, which results in shareholders being overtaxed. In particular, if a company that invests exclusively in tax exempt obligations distributes an amount greater than its net tax-exempt interest income for the year, that excess is economically a return of capital to shareholders. However, because deductions associated with tax-exempt income are disallowed, the excess is treated as a dividend out of current earnings and profits. The legislation would fix this by allowing certain disallowed deductions associated with tax-exempt income to be taken into account in calculating earnings and profits.
A regulated investment company is allowed to pass-through tax-exempt interest and foreign tax credits if more than fifty percent of its assets are comprised of municipal bonds or stock and securities issued by foreign corporations. However, if a RIC invests exclusively in shares of other RICs in a fund-of-funds structure that pass through tax-exempt interest or foreign tax credits, the top-tier RIC is limited in its ability to separately pass these tax attributes on to its shareholders because it does not technically meet this fifty percent requirement. As the mutual fund industry has evolved, this aspect of current law has become problematic for the many fund-of-funds structures. Thus, HR 4337 would allow a fund of funds that invests fifty percent of its assets in interests in other regulated investment companies to pass-through tax-exempt interest and foreign tax credits without regard to the fifty percent requirement.
Currently dividends paid by a RIC after the end of its taxable year may be taken into account in computing its dividends paid deduction for such taxable year. In order for a dividend to qualify for this spillover treatment, the RIC must declare the dividend by the due date for filing its tax return and pay the dividend to shareholders within the twelve months following the end of the taxable year and not later than the date of the first regular dividend paid by the RIC after such declaration. The requirement that a spillover dividend be paid no later than the next regular dividend paid after the spillover dividend is declared may unnecessarily restrict a RIC’s flexibility in determining when to make distributions. For example, a fund may wish to make a capital gain distribution before making its spillover dividend. The legislation would allow a RIC to make a spillover dividend with the first dividend payment of the same type of dividend and limit the time period for making a spillover dividend to the 15th day of the ninth month following the close of the taxable year.
If a regulated investment company makes a return of capital distribution it must allocate it pro rata over all distributions made during the taxable year. RICs are also required to distribute essentially all of their calendar-year income by December 3 in order to avoid the annual RIC excise tax. The interaction between these two rules can be problematic. If a RIC makes a computational error over the course of the taxable year, distributions that the RIC treats as dividends in the pre-January 1 period of the taxable year could turn out to be, in part, return of capital distributions. This can be particularly problematic for funds because they are required to track the cost basis of each share and also notify their shareholders of the amount of dividends that each shareholder receives during the calendar year.
Substantial confusion can arise if shareholders receive amended information returns and cost basis statements. In order to remedy this situation, HR 4337 would provide that a RIC’s earnings and profits shall be allocated first to distributions made prior to December 31 and then to distributions occurring after December 31 instead of requiring earnings and profits be allocated pro rata over all distributions during the taxable year.