/>iThe recently proposed regulations, if finalized, would govern the treatment of RICs’ income inclusions in respect of CFCs and PFICs for purposes of the income test applicable to RICs; in related guidance, the IRS also informed RICs that it would no longer issue letter rulings with respect to whether a financial instrument or position is a security.
On September 27, the Internal Revenue Service (IRS) and the US Department of the Treasury (Treasury) introduced proposed regulations (REG-123600-16). The regulations provide that amounts included in a regulated investment company’s (RIC’s) income under Section 951(a)(1)(A)(i) or 1293(a) of the Internal Revenue Code of 1986, as amended (the Code), in respect of the RIC’s investment in a “controlled foreign corporation” (CFC) or a “passive foreign investment company” (PFIC) (together, income inclusions) will only be treated as qualifying income for purposes of the income test applicable to RICs if the applicable CFC or PFIC makes a distribution attributable to the income inclusions. Concurrently, in Revenue Procedure 2016-50, the IRS stated that it will no longer rule on RIC-related issues that require it to determine whether a financial instrument or position is a security under the Investment Company Act of 1940, as amended (1940 Act).
Background
Under Section 851(b) of the Code, a corporation can qualify as a RIC for a taxable year only if it derives 90% or more of its gross income from certain qualifying sources. Such sources include dividends, interest, gains from the sale or other disposition of stock, securities or foreign currencies, and “other income . . . derived with respect to its business of investing in such stock, securities or currencies.” Further, to qualify as a RIC, a corporation must meet certain asset diversification requirements. The income test and the diversification requirements implicate the issue of whether a RIC’s investments are securities. For the purposes of these rules, the term security is defined by reference to the 1940 Act.
Although the US Securities and Exchange Commission (SEC) has the authority to define the term security under the 1940 Act, the IRS and Treasury have historically addressed whether certain financial instruments and positions are securities for purposes of Section 851 of the Code. Revenue Ruling 2006-1 concludes that a derivative contract with respect to a commodity index is not a security for purposes of the income test and does not generate “other income” within the meaning of the income test. Revenue Ruling 2006-31 modifies Revenue Ruling 2006-1, clarifying that Revenue Ruling 2006-1 is not intended to preclude a conclusion that income from certain instruments used to create commodity exposure for the holder could not be qualifying income for purposes of the income test.
After the IRS issued Revenue Ruling 2006-31, and to gain exposure to commodity-related investments, many RICs created offshore subsidiaries treated as CFCs to invest in commodity-related investments. In dozens of private letter rulings, the IRS ruled that the income inclusions a RIC was deemed to receive from a CFC subsidiary would generate qualifying income for purposes of the income test, regardless of whether the CFC made distributions in respect of the income inclusions. In many of those private letter rulings, the IRS also ruled that income derived from certain commodity-linked instruments would also constitute qualifying income for purposes of the income test. In 2011, the IRS suspended its practice of issuing rulings on these issues and indicated that it planned to study the relevant issues and would consider issuing guidance with broader applicability. A number of letter ruling requests on these issues were pending with the IRS at the time it suspended the issuance of rulings.
Proposed Regulations
The proposed regulations, if finalized, would establish that a RIC’s income inclusions from CFCs and certain PFICs are treated as dividends under the income test only to the extent that the CFCs and PFICs make distributions to the RIC out of earnings and profits attributable to the income inclusions. Further, contrary to the private letter rulings noted above, the proposed regulations would establish that income inclusions are not other income derived with respect to a RIC’s business of investing in stock, securities, or currencies, within the meaning of the income test.
Thus, if the proposed regulations were to be finalized in their current form, the status of RICs investing in certain CFCs and PFICs would be jeopardized if the CFCs and PFICs do not make distributions.
The proposed regulations would be effective for taxable years beginning on or after the date 90 days after the date of publication of a Treasury decision adopting the proposed regulations as final.
Revenue Procedure 2016-50
In Revenue Procedure 2016-50, the IRS stated that it would no longer issue letter rulings on any matter relating to the treatment of a corporation as a RIC if the matter would require a determination of whether a financial instrument or position is a security under the 1940 Act.
Comments
The IRS and Treasury have requested comments on the proposed regulations. Notably, the IRS and Treasury have asked for comments on whether they should withdraw Revenue Ruling 2006-1, Revenue Ruling 2006-31, and other previously issued guidance involving determinations of whether a financial instrument or position is a security under the 1940 Act.
The IRS has been contacting taxpayers with pending letter ruling requests that are affected by these authorities and indicating that it will not issue the requested rulings. The approach that the IRS intends to take in connection with the dozens of letter rulings that it previously issued on these matters is not entirely clear. The IRS generally has the authority to revoke or modify a letter ruling by, for example, a letter giving notice of revocation or modification to the taxpayer to whom the ruling was issued, the promulgation of temporary or final regulations, or the publication of a revenue ruling, revenue procedure, or notice in the Internal Revenue Bulletin. The proposed regulations have not at this point been issued in temporary or final form. Neither the proposed regulations nor Revenue Procedure 2016-50 specifically revokes or modifies any letter rulings. The IRS has the authority to revoke or modify a letter ruling with retroactive effect, but it also has discretion under Section 7805(b) to make a revocation or modification prospective only. Revenue Procedure 2016-1 provides that a revocation or modification ordinarily will not have retroactive effect in the case of a ruling on continuing actions or series of actions if the ruling is revoked or modified because it is found to be in error or no longer in accord with the position of the IRS.
It is not clear whether the IRS will issue letter rulings in this context that do not require it to determine whether any particular financial instrument or position is a security under the 1940 Act (e.g., rulings regarding whether particular income items are other income derived with respect to a RIC’s business of investing in stock, securities, or currencies within the meaning of the income test).
