A regulated investment company (“RIC”) is an electing domestic corporation that either meets (or is excepted from) (i) registration requirements under the Investment Company Act of 1940, (i) that derives at least 90 percent of its ordinary income from specified sources considered passive investment income, (iii) that has a portfolio of investments that meet mandated diversification requirements, and (iv) that meets certain other requirements.
A regulated investment company that also satisfies the “minimum distribution” rules is generally subject to tax in the same manner as a pass-through entity—that is, it serves as a conduit of income and gains to its ultimate shareholders, avoiding a corporate-level tax. In other words, unlike a C-corporation, a RIC can deduct dividends distributed to its shareholders. Common regulated investment companies include mutual funds, closed-end investment companies, and exchange-traded funds (“ETF”) that are not a “grantor trust” or partnership.
A RIC is a domestic corporation that meets several requirements, including certain election, gross income, and diversification requirements. To begin with, the corporation must be one of the following:
(1) registered with the Securities and Exchange Commission throughout the tax year as a management company or unit investment trust under the Investment Company Act of 1940 at all times during the tax year;
(2) have an election in effect under the Investment Company Act of 1940 to be treated as a business development company at all times during the tax year; or
(3) a common trust fund or similar fund excluded by section 3(c)(3) of the Investment Company Act of 1940 from the definition of “investment company.”
In addition, the entity must make an election to be treated as a regulated investment company. A RIC election is irrevocable.
The entity must, as well, derive at least 90% of its gross income from dividends, interest, payments with respect to certain securities loans, and gains from the sale or other disposition of stock or securities, or foreign currencies, or other income (including but not limited to gains from options, futures, or forward contracts) derived with respect to its business of investing in such stock, securities, or currencies, or net income derived from interests in “qualified publicly traded partnerships;”
Finally, the entity must meet quarterly diversification requirements with respect to its assets.
Each of these requirements is discussed in more detail below.
The Taxation of a RIC
Regulated investment companies receive unique tax treatment under Part I of Subchapter M of Chapter 1 of Subtitle A of the Internal Revenue Code of 1986, as amended (“Subchapter M”). A RIC is generally able to eliminate corporate tax liability on income that it distributes to shareholders; however, it remains subject to tax on income that it retains and does not distribute.
In summary, a RIC is generally taxed on investment company taxable income except:
- net capital gain is excluded (and is taxed separately, except for gain that is distributed, or treated as distributed, to the RIC’s shareholders);
- the net operating loss deduction and certain other deductions available to normal corporations are not allowed; and
- the RIC is allowed a deduction for dividends it pays to its shareholders (unless the dividend is preferential)
Unlike a C-corporation, a RIC can deduct dividends distributed to its shareholders. At least, a RIC that distributes at least 90 percent of its net ordinary income and net tax-exempt interest to its shareholders may deduct dividends paid in computing its tax. A RIC is therefore generally not subject to an entity-level tax on net investment income and net capital gain if it distributes these amounts to its shareholders within required time limits.
But a RIC that does not satisfy the distribution requirements will be subject to taxation as a C corporation.
A RIC utilizes Form 1120-RIC, U.S. Income Tax Return for Regulated Investment Companies, to report the income, gains, losses, deductions, credits, and to figure the income tax liability of a regulated investment company (RIC) as defined in section 851.
Shareholder Taxation
A RIC’s shareholders are generally subject to tax on distributions from the RIC’s investment company taxable income. That is, unlike with respect to a partnership, investors are only subject to tax on distributed earnings. Certain special rules, however, may apply.
Moreover, a RIC can pass through the character of (1) its long-term capital gain income, by paying “capital gain dividends” and (2) in certain cases, tax-exempt interest, by paying “exempt-interest dividends.” A RIC may also pass through certain foreign tax credits and credits on tax-credit bonds, as well as the character of certain other income received by the RIC.
Dividends-Received Deduction. A portion of a RIC’s dividends may qualify for the dividends-received deduction, subject to some restrictions.
Capital gains dividends. A RIC that has net capital gain for a taxable year may distribute capital gain dividends to its shareholders. Distributions from net capital gain are treated as long-term capital gain. A capital gain dividend is any dividend, or part thereof, that is designated by the RIC as a capital gain dividend in a written notice mailed to the RIC’s shareholders not later than 60 days after the close of the RIC’s taxable year, except that in the event a RIC designates an aggregate amount of capital gain dividends for a taxable year that exceeds the RIC’s net capital gain, the portion of each distribution that is a capital gain dividend is only that proportion of the designated amount that the RIC’s net capital gain bears to the total amount so designated by the RIC.
Exempt-Interest Dividends. A RIC may designate any portion of a dividend (other than a capital gain dividend) as an “exempt-interest dividend,” if at least half of the RICs assets consist of tax-exempt State and local bonds. The shareholder treats an exempt-interest dividend as an item of tax-exempt interest. Exempt-interest dividends are defined as any dividend, or part thereof, that is designated by the RIC as an exempt-interest dividend in a written notice mailed to the RIC’s shareholders not later than 60 days after the close of the RIC’s taxable year, except that in the event a RIC designates an aggregate amount of exempt-interest dividends for a taxable year that exceeds the RIC’s tax-exempt interest (net of related deductions disallowed under sections 265 and 171(a)(2) by reason of the interest being tax-exempt), the portion of each distribution that will be an exempt-interest dividend is only that proportion of the designated amount that net exempt interest bears to the amount so designated.
Foreign tax credits; credits for tax-credit bonds; dividends received by RIC. RICs may pass through to shareholders certain foreign tax credits, credits for tax-credit bonds, and dividends received by the RIC that qualify, in the case of corporate shareholders, for the dividends received deduction, or, in the case of individual shareholders, the capital gain rates in effect for dividends received. In each case the qualifying amount must be designated in a written notice mailed to its shareholders not later than 60 days after the close of the RIC’s taxable year.
Excise Tax. An excise tax is imposed on a RIC for a calendar year equal to four percent of the excess (if any) of the required distribution over the distributed amount. The required distribution is the sum of 98 percent of the RIC’s ordinary income for the calendar year and 98 percent of the capital gain net income for the one-year period ending October 31 of such calendar year. The distributed amount is the sum of the deduction for dividends paid during the calendar year and the amount on which a corporate income tax is imposed on the RIC for taxable years ending during the calendar year.
Electing RIC Status
The Internal Revenue Code requires that the corporation make a timely election to be treated as a regulated investment company. That is, a corporation will not be considered a RIC for any taxable year unless it files with its return for the taxable year an election to be a RIC or has made such election for a previous year.
Under Treasury Regulations, the election must be made by computing taxable income as a RIC on the corporation’s return for the first taxable year for which the election is applicable and filing a federal income tax return on Form 1120- RIC.
The Gross Income Test
In order to qualify as a regulated investment company, the entity must derive at least 90% of its gross income from dividends, interest and similar income items earned in its business of investing in stock, securities, and currencies.[3] Notably, any loss from the sale or other disposition of stock or securities is not taken into account in the gross income computation.
More particularly, the income at issue must fall within one of the following categories:
- Dividends; including amounts included in income under Code Sec. 951(a)(1)(A) (relating to controlled foreign corporations (CFCs)), and Code Sec. 1293(a) (relating to passive foreign investment companies (PFICs) to the extent that there are distributions out of the earnings and profits (E&P) of the tax year which are attributable under Code Sec. 959(a)(1) or Code Sec. 1293(c) to the amounts included in gross income;
- Interest;
- Payments with respect to securities loans (as defined in section 512(a)(5));
- Gains from the sale or other disposition of stocks or securities (as defined in section 2(a)(36) of the Investment Company Act of 1940, as amended);[1]
- Gains from the sale or other disposition of foreign currencies; or
- Other income (including but not limited to gains from options, futures, or forward contracts) derived with respect to the corporation’s business of investing in such stock, securities, or currencies.
- Income from a publicly traded partnership.[2]
Limits on Short-Term Gains from Disposition of Stock. A regulated investment company must derive less than 30 percent of its gross income from the sale or other disposition of stock or securities held for less than three months.
Commodities and Derivatives. In general, because direct investments in commodities are not “securities” under section 2(a)(36) of the Investment Company Act of 1940, they do not generate “qualifying income” for purposes of the 90 percent gross income test. Similarly, the IRS has ruled that derivative contracts with respect to commodity indexes are not securities for the purposes of the gross income tests. On the other hand, in a series of private rulings, the IRS has held that certain notes, with payout formulas determined with reference to a commodities index, produce qualifying income for purposes of the gross income test. The IRS also has held that income of a RIC derived from investments in commodities by a wholly-owned foreign subsidiary of the RIC is qualifying income for purposes of the gross income test.
The Diversification Test
In addition to the income test above, the Internal Revenue Code provides that a corporation will not be considered a RIC for any taxable year unless it meets an asset test (the “asset test”). Under this test, at least 50 percent of its total assets must be represented by cash, cash items, Government securities, securities of other RICs, and “other securities.”
The 50% diversification test
The Code requires that at the close of each quarter of the year, at least 50 percent of the value of the entity’s assets must be represented by cash and cash items (including receivables), U.S. government securities, securities of other RICs, and securities of other issuers as to which the investment in the securities of any one issuer is limited to an amount which does not exceed in value 5% of the value of the taxpayer’s total assets, and, in voting power, 10% of the outstanding voting securities of the issuer.[4]
The 50 percent diversification test is applied with respect to each entity that is a regulated investment company and may not be applied at the parent level on a combined asset basis.
The 25% diversification test
In addition to the 50-percent diversification test, the Code imposes a separate and distinct 25-percent test as well. Under the 25-percent test, at the end of each quarter of the RIC’s tax year, no more than 25% of the value of the RIC’s assets may be invested in the securities of:
- A single issuer (excluding government securities or securities of other RICs);
- Two or more issuers controlled by the RIC and engaged in the same or related trades or businesses; or
- One or more qualified publicly traded partnerships as defined in section 851(h).
No securities of a single issuer can exceed 25% of the RIC’s total assets.
De minimis failures. A RIC that fails to meet the requirements of section 851(b)(3) for a quarter may be considered to have satisfied the requirements of this test if:
- Such failure is due to ownership of assets that the total value does not exceed the lesser of:
- One percent of the total value of the RIC’s assets at the end of the quarter, or
- $10 million.
- The RIC disposes of the asset following the identification of the failure (or the requirements of section 851(b)(3) are otherwise met) within 6 months after the last day of the quarter in which the RIC identified the failure.
Distribution requirements
A fund that satisfies the requirements above will qualify to be treated as a RIC. However, to qualify for pass-through treatment under Subchapter M, the RIC must also satisfy a distribution test. It must distribute to its shareholders at least 90% of its “investment company taxable income” and net interest income excludable from gross income under section 103(a).
Investment company taxable income” is generally defined as: (1) net investment income, (2) the excess of net short-term capital gain over net long-term capital loss (“short-term capital gain”), and (3) net gains and losses from certain foreign currency transactions — without regard to the dividends-paid deduction.
The RIC’s deduction for dividends paid for the tax year equals or exceeds the sum of:
- 90% of its investment company taxable income (determined without regard to the deduction for dividends paid); and
- 90% of the excess of the RIC’s interest income excludable from gross income under section 103(a) over its deductions attributable to such interest which are disallowed under §265 (expenses and interest relating to tax-exempt income) and §171(a)(2) (amortizable bond premium of tax-exempt bonds).
Generally, RICs attempt to distribute all investment company taxable income and net capital gains, as the RIC would otherwise be subject to tax on any undistributed income and gains.
[1] Section 2(a)(36) of the Investment Company Act of 1940 defines a “security” as “any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security (including a certificate of deposit) or on any group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”
[2] A “qualified publicly traded partnership” means a publicly traded partnership (within the meaning of section 7704(b)), other than a publicly traded partnership whose gross income is qualifying income (other than income of another publicly traded partnership). Sec. 851(h).
[3] Section 851(b)(2) of the Code provides that, to qualify as a RIC, at least 90 percent of a corporation’s gross income must be derived from dividends, interest, payments with respect to securities loans (as defined in section 512(a)(5)), gains from the sale or other disposition of stocks, securities, foreign currencies, or other income derived with respect to the business of investing in such stocks, securities, or currencies.
[4]At least 50% of the RIC’s total assets must be represented by cash, receivables, U.S. government securities, securities of other RICs, and securities of other issuers as to which the investment in the securities of any one issuer may not exceed 5% of the value of the RIC’s total assets and 10% of the voting power of the issuer.
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