Income Tax Expense

6.03 Federal income tax expense normally is not paid by investment companies that qualify under IRC Subchapter M,¹ and distribute all their investment company taxable income and taxable realized gains from securities transactions. For investment companies that qualify as regulated investment companies (RICs) under Subchapter M of the IRC (see the “Qualification Tests” section beginning at paragraph 6.45 for qualification criteria), federal income taxes payable on security gains that the investment company elects to retain (see paragraph 6.40) are accrued only on the last day of the tax year.² Only shareholders of record on the last day of the fiscal year are entitled to the credit for income taxes paid by the fund with respect to related gains. Information regarding retained gains and taxes paid is sent to those shareholders to enable them to report their proportionate share of the gains and taxes paid on their individual returns. Also, no expense for federal excise taxes is required if a fund timely distributes substantially all of its taxable ordinary income, calculated generally on a calendar-year basis, and substantially all of its taxable capital gains, calculated generally on the basis of a 12 month period ending October 31 (see paragraph 6.84). Excise taxes imposed on underdistributed income should be recorded when determinable.

6.04 Income tax expense related to net investment income and net realized gains on investments should be recorded when it is probable that an investment company subject to IRC Subchapter M will not qualify under that subchapter. Management should consider the need for recording a deferred tax expense if management concludes that it is probable that the investment company will not meet its qualification requirements for a period longer than one year. The auditor might consider assessing the assumptions used by an entity in determining its income tax status under IRC Subchapter M.

6.05 Some investment companies may be subject to state, local, or foreign taxes on net investment income and realized gains on a recurring basis. State, local, and foreign taxes, if payable, are reported on the accrual basis, including deferred taxes on the unrealized appreciation or depreciation of investments. A valuation allowance should be established for any deferred tax asset resulting from temporary differences related to unrealized depreciation that could result in deductible amounts in future years when the probability of realization of the tax benefit does not meet the more likely than not criterion of FASB Accounting Standards Codification (ASC) 740-10-25-6.

6.06 FASB ASC 740, Income Taxes, clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FASB ASC 740 also provides guidance on derecognition, classification, interest and penalties, accounting for interim periods, disclosure, and implementation and addresses financial accounting and reporting for the effects of income taxes that result from an entity’s activities during the current and preceding years. FASB ASC 740 establishes standards of financial accounting and reporting for income taxes that are currently payable and for the tax consequences of the following: revenues, expenses, gains, or losses that are included in taxable income of an earlier or later year than the year in which they are recognized in financial income; other events that create differences between the tax bases of assets and liabilities and their amounts for financial reporting; and operating loss or tax credit carrybacks for refunds of taxes paid in prior years and carryforwards to reduce taxes payable in future years. The scope of FASB ASC 740 includes domestic and foreign entities preparing financial statements in accordance with U.S. generally accepted accounting principles. FASB ASC 740-10-25-10 provides the conditions an entity should evaluate to determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. It uses the terms effectively settled and settlement in the context of income taxes.

6.07 FASB ASC 740-10-15-2AA clarifies that the sections of FASB ASC 740-10 relating to accounting for uncertainty in income taxes applies to all entities, including tax-exempt not-for-profit entities, pass-through entities, and entities that are taxed in a manner similar to pass-through entities such as real estate investment trusts and registered investment companies. Tax position, as defined by the FASB ASC Master Glossary, is a position in a previously filed tax return or a position expected to be taken in a future tax return that is reflected in measuring current or deferred income tax assets and liabilities for interim or annual periods. A tax position can result in a permanent reduction of income taxes payable, a deferral of income taxes otherwise currently payable to future years, or a change in the expected realizability of deferred tax assets. The term tax position also encompasses, but is not limited to, the following:

•     A decision not to file a tax return

•     An allocation or a shift of income between jurisdictions

•     The characterization of income or a decision to exclude reporting taxable income in a tax return

•     A decision to classify a transaction, an entity, or other position in a tax return as tax exempt

•     An entity’s status, including its status as a pass-through entity or a tax-exempt not-for-profit entity

6.08 FASB ASC 740-10-50-15(c)–(e) discusses required disclosures by all entities related to unrecognized tax benefits. At the end of each annual reporting period, an entity is required to disclose the total amounts of interest and penalties recognized in both the statement of operations and statement of financial position; for positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly increase or decrease within 12 months of the reporting date, the nature of the uncertainty, the nature of the event that could occur in the next 12 months that would cause the change, and an estimate of the range of the reasonably possible change or a statement that an estimate of the range cannot be made; and a description of tax years that remain subject to examination by major tax jurisdictions.

6.09 FASB ASC 740-10-45 discusses presentation requirements for all entities related to unrecognized tax benefits. With the exception of certain specific circumstances, an unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward. An exception to this presentation is described in FASB ASC 740-10-45-10B, which states

to the extent a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date under the tax law of the applicable jurisdiction to settle any additional income taxes that would result from the disallowance of a tax position or the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit shall be presented in the financial statements as a liability and shall not be combined with deferred tax assets.

6.10 As explained in FASB ASC 740-10-50-15A, in addition to the nonpublic entities’ disclosure requirements discussed in FASB ASC 740-10-50, public entities should disclose a tabular reconciliation of the total amounts of unrecognized tax benefits at the beginning and end of each period and the total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate.

6.11 Example 30 in FASB ASC 740-10-55-217 gives sample disclosures relating to uncertainty in income taxes. Further, paragraphs 223–229 of FASB ASC 740-10-55 include examples of defining a tax position, attribution of income taxes to the entity or its owners, and reporting tax positions for a group of related entities. Per FASB ASC 740-10-50-16, a public entity that is not subject to income taxes because its income is taxed directly to its owners should disclose that fact and the net difference between the tax bases and the reported amounts of the entity’s assets and liabilities.

6.12 On December 22, 2006, the staff of the SEC’s Division of Investment Management issued a letter to the Investment Company Institute on the implementation of accounting for uncertainty in income taxes by registered investment companies. In that letter, the staff

•     expressed its belief that the guidance “places [no] limits on the type of evidence that an enterprise can look to in making its determination of the technical merits of a tax position” and that a registered investment company may consider “less formal forms of guidance from [a] taxing authority,” weighing “all available forms of evidence based on their persuasiveness.”

•     observed that “the administrative practices and precedents of [a] taxing authority should be considered in fund’s analysis” regarding whether a tax position meets the recognition threshold, including any practice, to the extent that such exists, of addressing industry taxation issues on a prospective basis.

Federal Income Tax Provisions Affecting Investment Accounts

6.13 In establishing investment policies, companies intending to qualify as RICs under IRC Subchapter M must comply with the requirements of Subchapter M relating to diversification of assets, sources of income and realized gains, and similar matters. Those requirements are described later in this chapter.

Foreign Withholding Taxes

6.14 As stated in FASB ASC 946-830-45-34, whenever tax is withheld from investment income at the source, the amounts withheld that are not reclaimable should be accrued, along with the related income on each income recognition date if the tax rate is fixed and known. If the tax withheld is reclaimable from the local tax authorities, it should be recorded as a receivable, not an expense. When the investment income is received net of the tax withheld, a separate realized foreign currency gain or loss should be computed on the gross income receivable and accrued tax expense. If the tax rate is not known or estimable, such expense or receivable should be recorded on the date that the net amount is received; accordingly, there would be no foreign currency gain or loss. However, if a receivable is recorded, there may be a foreign currency gain or loss through the date that such receivable is collected.

Financial Statement Presentation

6.15 FASB ASC 946-225-45-4 explains that income tax expense should be presented by investment companies under the separate income categories (such as investment income or realized and unrealized gains) to which it applies. In addition, taxes in certain foreign jurisdictions may be based on the net investment income and realized gains of the fund within that jurisdiction; the guidance in FASB ASC 740 is applicable to such taxes. According to FASB ASC 946-225-45-3(h), other taxes, such as foreign withholding taxes, should be deducted from the relevant income item and disclosed parenthetically or shown as a separate contra item in the “Income” section. FASB ASC 946-225-45-6(b)(1) states that major components of unrealized appreciation or depreciation for investments shall be disclosed and any provision for deferred taxes should be presented separately.

Diversification of Assets

6.16 As noted in paragraph 8.52–.53 of this guide, the diversification requirements appearing in an investment company’s prospectus and specified in various SEC rules and interpretations may differ from those in IRC Subchapter M, discussed later in this chapter.

General Discussion of the Taxation of RICs

6.17 This chapter discusses, in general terms, the requirements for qualification and taxation as a RIC under IRC Subchapter M, as well as the excise tax on certain undistributed taxable income and certain other federal tax matters affecting investment companies. (Although many states and municipalities have adopted provisions similar to Subchapter M, a discussion of state and local taxes is beyond the scope of this chapter, as is discussion of the tax aspects of investment companies formed as partnerships.) In designing the detailed audit plan, the auditor should refer to the latest IRC, Treasury regulations, and IRS rulings and applicable state laws to be certain that all requirements for qualification have been covered and to determine the need for accruing income, excise, or other taxes.

Taxation of a RIC’s Taxable Income and Net Capital Gains

6.18 An investment company organized as a corporation or as a business trust is taxable as a corporation and, as such, subject to federal income taxes and certain state and local taxes the same as any other domestic corporation. However, if the investment company is registered under the Investment Company Act of 1940 (the 1940 Act) or elects to be treated as a business development company under the 1940 Act, it may elect to qualify under the IRC for special federal income tax treatment as a RIC, which allows it to deduct dividends paid to shareholders and if certain requirements are met to pass through tax-favored income, such as capital gains and tax-exempt income (see the “Taxation of Shareholder Distributions” section beginning at paragraph 6.25). A dividend, for this purpose, is defined as a distribution of current or accumulated earnings and profits (E&P). Thus, an investment company distributing all its taxable income to its shareholders would have no taxable income and, therefore, no tax liability. If an investment company fails to qualify as a RIC, it will be taxed as a regular corporation. The deduction for dividends paid by the investment company will not be available, and all distributions out of E&P will be taxed as ordinary income to shareholders. The effects of the failure to qualify may extend beyond the income tax consequences because net asset values may be improperly stated in such situations.

6.19 Certain investment companies are organized as series funds. Additionally, shareholders of each respective portfolio may have separate rights with respect to each portfolio’s net assets. A series fund includes several portfolios, each of which may have a different investment objective. Series funds are required to treat each segregated portfolio of assets as a separate corporation for tax purposes (IRC Section 851(g)).

6.20 To determine if a RIC has a federal income tax liability, the RIC’s investment company taxable income and net capital gain must be computed separately. Investment company taxable income is regular taxable income modified by certain adjustments. The following are among those adjustments:

•     Net capital gain (that is, net long term capital gain for the taxable year in excess of any net short term capital loss for such year) is excluded (IRC Section 852(b)(2)(A)).

•     Net operating losses are not allowed as a deduction (IRC Section 852(b)(2)(B)).

•     The corporate deduction for dividends received is not allowed (IRC Section 852(b)(2)(C)).

•     The deduction for dividends paid is allowed (as computed without regard to capital gain dividends and exempt-interest dividends) (IRC Section 852(b)(2)(D)).

•     The tax imposed by subsections (d)(2) and (i) of IRC Section 851 for failures to satisfy the gross income or assets tests, or both, for the taxable year is deducted (IRC Section 852(b)(2)(G)).

6.21 Note that although investment company taxable income excludes net capital gain, it includes net short term capital gain in excess of net long term capital loss. Subsequent to the enactment of the Regulated Investment Company Modernization Act of 2010, a capital loss (called a postenactment capital loss), incurred by a RIC in taxable years beginning after December 22, 2010, retains its character as short term or long term, and can be carried forward without expiration (IRC Section 1212(a)(3)). Net capital losses incurred by a RIC in taxable years beginning before December 23, 2010 (preenactment capital losses), continue to be treated as short term and, to the extent not used, expire eight taxable years after the taxable year of their origination. Preenactment capital losses may not be used to offset capital gains until all postenactment capital losses have been utilized. As a result, some capital loss carryovers incurred by a RIC in preenactment years that would have been utilized under prior law may expire unused. A RIC is prohibited from claiming a net operating loss deduction (IRC Section 852(b)(2)(B)). Because net short term capital gains are considered ordinary income for IRC purposes, a net investment loss incurred in the same taxable year may be offset against any net short term capital gains. However, if the net investment loss exceeds net short term gains, such net investment loss may not be carried forward and deducted as a net operating loss.

6.22 In order for a RIC to eliminate the imposition of any entity-level federal income tax liability, it must distribute ordinary dividends to shareholders sufficient to offset investment company taxable income and capital gain dividends sufficient to offset net capital gain.

6.23 The RIC’s investment company taxable income may be reduced to zero by dividends other than capital gain dividends and exempt-interest dividends paid to shareholders from a RIC’s E&P. The RIC’s net capital gain may be offset by a capital gain dividend paid by the RIC to its shareholders and reported as a capital gain dividend in written statements furnished to its shareholders (IRC Section 852(b)(3)(C)). The computation of a RIC’s required annual distributions to shareholders is discussed in further detail in the “Distribution Test” section beginning at paragraph 6.64.

6.24 An investment company that does not meet all the RIC qualification requirements in a taxable year will be taxed as a regular corporation for that year and must comply with provisions in a subsequent year if it elects to be taxed as a RIC, as follows:

a.     When a regular corporation makes a qualified election to be subject to tax as a RIC, the RIC generally will be subject to entity-level tax on the net built-in gain in the corporation’s assets if the RIC recognizes such gain within 5 years.³ Gain recognition applies even if the RIC distributes the recognized, built-in gain to investors. These consequences to the RIC can be avoided, however, if the regular corporation makes a “deemed sale election” with respect to its assets which become property of the RIC. Under the deemed sale election, the regular corporation recognizes gain or loss as if its assets were sold to an unrelated party at fair market value at the end of the last day of the corporation’s last taxable year before the first taxable year in which it qualifies to be taxed as a RIC (Treasury Regulations 1.337(d)-7(c)). This general rule is designed to prevent regular corporations with appreciated assets from qualifying as a RIC, selling the assets at a gain, and eliminating corporate-level tax by distributing all income to the shareholders of the RIC.

b.     From the general rule discussed previously, it might appear that a RIC disqualified in one taxable year but qualifying the next year would owe a corporate-level tax on the net built-in gain of its assets, if they were recognized within 5 years. However, an exception to the general rule is provided stating that a previously qualifying RIC that fails to meet the requirements of the RIC tax provisions for a period not exceeding two taxable years and then requalifies as a RIC will not be subject to the otherwise applicable gain recognition rules (Treasury Regulations 1.337(d)-7(d)(2)).

c.     A corporation that accumulates E&P in a year in which it is not taxed as a RIC is required to distribute such E&P before the end of its RIC year if it wishes to be taxed as a RIC in such year (IRC Section 852(a)(2) and Treasury Regulation 1.852-12).

Taxation of Shareholder Distributions

6.25 A dividend is a distribution from current year E&P or E&P accumulated in prior taxable years. E&P is generally determined by adjusting taxable income for items that constitute economic income or deductions (Treasury Regulation 1.312-6). Under Subchapter M, the amount of a RIC’s E&P is generally adjusted so that the full amount of a RIC’s income otherwise subject to corporate taxation is taxable to shareholders if currently distributed (IRC Sections 561 and 852(c)). Examples of these adjustments include tax-exempt income, amortization of organization costs, and federal income taxes. Expenses and premium amortization allocated to tax-exempt income reduce current E&P. E&P for a taxable year are not reduced by a net capital loss of a RIC for such year. Any capital loss carried over that is treated as arising on the first day of the next taxable year is taken into account in determining E&P for such next taxable year (subject to the application of the net capital loss rules for that year). For excise tax purposes, E&P are not reduced for any capital loss carryforwards (IRC Section 852(c), as amended by Section 205, Amendments relating to Regulated Investment Company Modernization Act of 2010, of the Tax Increase and Prevention Act of 2014).

6.26 Distributions from a RIC are reported to shareholders on Form 1099-DIV as all of the following:

a.     Ordinary dividends, to the extent of the RIC’s current or accumulated E&P (IRC Sections 301(c)(1) and 316)

b.     Nontaxable distributions (that is, return of capital), to the extent that distributions paid within a RIC’s taxable year exceed the RIC’s current and accumulated E&P (IRC Section 301(c)(2))

c.     Long term capital gains (IRC Section 852(b)(3))

d.     Qualified dividends (IRC Sections 1(h)(11)(D)(ii) and 854)

e.     IRC Section 1202 gains on certain small business stock (IRC Section 1202(g))

f.     IRC Section 1250 depreciation recapture, generally from dividends received by the RIC from real estate investment trusts

g.     Collectibles gains, generally from investments in precious metals

h.     Foreign taxes paid by the RIC (IRC Section 853)

i.     Exempt-interest dividends (IRC 852(b)(5))

j.     Investment expenses in the case of a non-publicly offered RIC (IRC Section 67(c)(1) and Treas. Reg. 1.67-2T(g)(1)(v))

6.27 If a RIC has made distributions during a taxable year in excess of its current and accumulated E&P, it is required to file Form 5452 with its Form 1120-RIC and report the taxable and nontaxable components of such distributions to its shareholders on Form 1099-DIV. A RIC is also required to file a Form 8937 reporting any return of capital occurring during or after 2012 as an “organizational action” affecting shareholder basis (IRC Section 6045B). For taxable years beginning after December 22, 2010, E&P is allocated first to distributions paid during the portion of the taxable year on or before December 31 (IRC Section 316(b)(4)). For prior years, IRC and Treasury regulations require the pro rata allocation of E&P among all distributions during the taxable year.

6.28 A dividend from investment company taxable income may qualify in whole or part for the dividends-received deduction available to corporate shareholders (IRC Sections 854(b) and 243).

6.29 A dividend does not qualify for the dividends-received deduction if the stock on which the dividend was paid is held for less than 46 days during a 91-day period that begins 45 days before the stock becomes ex-dividend with respect to the dividend (or, for certain preferred stock, less than 91 days during a 181-day period that begins 90 days before the stock becomes ex-dividend). The holding period generally is suspended for this purpose during any time that the RIC has diminished its risk of loss (for example, through hedging) (IRC Section 246(c)).

6.30 The portion of the dividend qualifying for the dividends-received deduction must be reported in a written statement furnished to its shareholders for the RIC’s tax year in which the dividend was paid (IRC Sections 854(b)(1)).

6.31 If greater than 50 percent of the fair market value of the RIC’s gross assets comprises, at the end of the taxable year, stock or securities of foreign corporations or, at the close of each quarter of a taxable year, at least 50 percent of the fair market value of the RIC’s gross assets comprises shares of other RICs, the RIC may elect to pass through to its shareholders the foreign source character of certain investment income earned, as well as foreign income taxes that the RIC paid during such taxable year in respect to such foreign source income (IRC Sections 853(a)-(b) and 852(g)). A RIC that makes this election is not entitled to a tax deduction for the expense or a foreign tax credit in respect to such foreign taxes. However, the RIC is entitled to treat such foreign income taxes passed through to its shareholders as part of the RIC’s dividends paid deduction.

6.32 Shareholders must report as taxable income the gross income received from the RIC (increased by any foreign income taxes deemed passed through by the RIC) and are entitled to either a foreign tax credit (subject to certain limitations) or a deduction (subject to other limitations) for their allowable share of foreign taxes paid by the RIC and passed through to them (IRC Section 853(b)(2)). To claim or pass through a foreign tax credit, a RIC must hold the stock for at least 16 days within the 31-day period beginning 15 days before the ex-dividend date (46 days within the 91-day period for certain preferred stock) (IRC Section 901(k)). The holding period generally is suspended for this purpose during any time that the RIC has diminished its risk of loss (for example, through hedging). Foreign taxes paid by a RIC that do not qualify for the foreign tax credit do not increase the taxable income reported to the shareholders (that is, the RIC is allowed to deduct such taxes in computing its investment company taxable income) (IRC Section 853(e)).

6.33 The amount of foreign source income and foreign taxes must be reported by a RIC in a written statement furnished to shareholders for the RIC’s tax year in which the dividend was paid (IRC Section 853(c)).

6.34 A RIC that, at the end of each quarter of its taxable year, has at least 50 percent of its assets comprising federally tax-exempt obligations or shares of other RICs is eligible to distribute exempt-interest dividends to its shareholders. Exempt-interest dividends received by a shareholder are treated as federally tax-exempt income (IRC Sections 852(b)(5) and 852(g)).

6.35 The maximum amount reported as exempt-interest dividends may not exceed the net tax-exempt interest earned by a RIC eligible to distribute exempt-interest dividends. Net tax-exempt interest is defined as tax-exempt interest income reduced for the amortization of premium on tax-exempt bonds and also for expenses attributable to the production of its tax-exempt interest income (IRC Section 852(b)(5)(A)).

6.36 Generally, an acceptable basis for allocation of a RIC’s expenses allocable to tax-exempt income is the ratio of gross tax-exempt income to gross investment income (tax exempt plus taxable), excluding capital gain net income (IRC Sections 265(a)(3) and 1222(9)). The required amortization of premium on tax-exempt bonds must be allocated to the tax-exempt income (IRC Section 171(a)(2)).

6.37 Net gain or loss realized on the sale of tax-exempt securities is treated as capital gain or loss, except to the extent of any gain treated as market discount, which is taxable as ordinary income.

6.38 An exempt-interest dividend must be reported by a RIC in a written statement furnished to a shareholder for the RIC’s tax year in which the dividend was paid (IRC Section 852(b)(5)(A)). However, if the aggregate reported amount of a RIC’s exempt-interest dividends in respect of the RIC’s taxable year exceeds the RIC’s net tax-exempt income for such taxable year, the RIC would be eligible to treat as an exempt-interest dividend for such taxable year only an amount equal to the RIC’s net tax-exempt income for such taxable year (IRC Section 852(b)(5)(A)(ii)).

6.39 A capital gain dividend is any dividend reported as such by a RIC in a written statement furnished to shareholders (IRC Section 852(b)(3)(C)). A capital gain dividend distributed by a RIC to a shareholder is generally characterized as long term capital gain by the shareholder, regardless of the actual holding period of the shareholder’s shares in such RIC (IRC Section 852(b)(3)(B)).

6.40 A RIC may retain all or any portion of its net capital gain and elect to have shareholders include the gain in their taxable income as though a capital gain dividend had been paid. In such a case, the RIC will pay corporate income tax (currently 35 percent) on the undistributed net capital gain within 30 days of its year-end and notify shareholders within 60 days of the RIC’s tax year-end of the allocable retained capital gain and related income tax paid (IRC Sections 852(b)(3)(D)(i) and (iv)). The gain is treated as long term capital gain, and the tax is treated as a tax payment by the shareholders (IRC Section 852(b)(3)(D)(ii)). Each shareholder is entitled to increase the basis of his or her shares by a percentage (currently 65 percent) of the deemed distribution (IRC Section 852(b)(3)(D)(iii)). Notification must be provided to shareholders on Form 2439 (Treasury Regulation 1.852-9).

6.41 A RIC may also retain all or any portion of the net capital gain and pay the income tax thereon without notifying shareholders. In this situation, the shareholders will not include the capital gain as income nor will they receive a credit for the taxes paid by the RIC or an adjustment to the basis of their shares held.

6.42 A noncorporate taxpayer may generally exclude from taxable income 50 percent of capital gains resulting from the sale of certain qualified small business stock held for more than 5 years (IRC Section 1202). Such gains, however, are taxed (before exclusion) at a rate of 28 percent. To qualify for this exclusion, the stock must be acquired directly by the taxpayer (or indirectly, for example, through a RIC) at its original issuance after August 10, 1993; must be held by the RIC for more than 5 years; and the noncorporate taxpayer must hold shares of the RIC on the date that the RIC acquired the qualified small business stock and at all times thereafter until disposition of the stock by the RIC (IRC Section 1202(g)). For stock acquired after February 17, 2009, and on or before September 27, 2010, the exclusion is increased to 75 percent (IRC Section 1202(a)(3)). For stock acquired after September 27, 2010, and before January 1, 2015, the exclusion is 100 percent (IRC Section 1202(a)(4)).

6.43 Certain types of ordinary dividends received by a RIC may be reported as qualified dividend income (QDI) and are eligible for individual taxation at capital gains rates (IRC Section 1(h)(11)). The American Taxpayer Relief Act of 2012 made the treatment permanent. In order for dividends received by a RIC to be considered QDI, a RIC must hold the stock for at least 61 days within a 121 day period beginning 60 days before the ex-dividend date (91 days within a 181 day period for certain preferred stock). The holding period generally is suspended for this purpose during any time that the RIC has diminished its risk of loss (for example, through hedging) (IRC Section 1(h)(11)(B)).

Excess Reported Amounts

6.44 For RICs with taxable years other than the calendar year, the RIC’s net capital gain is allocated first to distributions reported to shareholders as capital gain dividends during the portion of the taxable year ending on December 31, so that any excess reported amounts are allocated first to amounts reported as capital gain distributions after December 31 (IRC Section 852(b)(3)(C)(iii)(II)). Similar rules apply to other pass-through items, such as tax-exempt interest (IRC Section 852(b)(5)(A)(iii)(II)), and qualified interest income⁴ and short term capital gains distributed to non-U.S. shareholders.⁵ For taxable years of a RIC beginning on or before December 22, 2010, any excess was allocated pro rata among all distributions designated as capital gain during the taxable year.

Qualification Tests

6.45 Requirements for qualification. To qualify as a RIC for tax purposes, an investment company must meet all of the following requirements:

a.     Be a domestic corporation (or a business trust taxable as a corporation) registered for the entire taxable year under the 1940 Act or have an election in effect to be treated as a business development company under the 1940 Act (IRC Section 851(a)). An investment company is registered upon filing its notification of registration on Form N-8A.⁶ An issuer must first file a notification of registration with the SEC on Form N-8A in order to register as an investment company. After filing the notification of registration, a registration statement must be filed on the appropriate form within 3 months. Common forms used are Form N-1A (Registration form for mutual funds) and Form N-2 (Registration for closed end funds). A comprehensive list of forms can be obtained on the SEC’s website.

b.     Elect, if it has not previously done so, to be taxed as a RIC (IRC Section 851(b)(1)). To elect RIC status, an investment company prepares and timely files a federal income tax return computing taxable income in accordance with the provisions of Subchapter M. Once elected, the company’s status is unchanged as long as the company continues to qualify as a RIC under the IRC.

c.     Meet the 90 percent gross income test (see paragraphs 6.48–.52).

d.     Meet certain requirements concerning diversification of its total assets at the end of each quarter of the taxable year (see paragraphs 6.53–.57).

6.46 In order for its distributions to be used to offset taxable income, the RIC must distribute at least 90 percent of its investment company taxable income (which includes net short term capital gains, if any) and net tax-exempt income for the taxable year (see the “Distribution Test” section beginning at paragraph 6.64).

6.47 A RIC should keep a record of the computations supporting qualification under the foregoing tests.

6.48 90 percent gross income test. A RIC must derive at least 90 percent of its gross income from (a) dividends; interest (including tax-exempt interest income); payments with respect to securities loans; and gains (without including losses) 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) or foreign currencies or (b) other income (including but not limited to gains from options, futures, or forward contracts) derived with respect to the RIC’s investing in such stock, securities, or currencies and net income from an interest in a qualified publicly traded partnership (PTP) (IRC Section 851(b)(2)).

6.49 Although the IRS may issue regulations that would exclude from qualifying income foreign currency gains that are not directly related to the RIC’s principal business of investing in stock or securities (or options and futures with respect to stock or securities), no such guidance has been issued.⁷

6.50 For a partnership that is not a qualified publicly traded partnership, gross income (distinguished from what is generally reported on the partner’s Form K-1 as taxable income or from cash distributions received by the partner during the year) is treated by the RIC in the same manner as if it were realized directly by the RIC for purposes of the 90 percent gross income test (IRC Section 851(b)). Thus, gross income earned by a partnership other than income described in paragraph 6.48 would be treated by a RIC partner of such partnership as nonqualifying income.

6.51 Other items of gross income, such as redemption fees, expense reimbursements, and lawsuit settlements, may require individual consideration to determine their tax status and effect on the 90 percent gross income test. The IRS has ruled that if in the normal course of its business a RIC receives a reimbursement of investment advisory fees that was not the result of a transaction entered into to artificially inflate the RIC’s qualifying gross income, such reimbursement may be considered qualifying income for purposes of the 90 percent test (Revenue Ruling 92-56).

6.52 An investment company that fails to meet the 90 percent gross income test would not lose its RIC status if such failure is due to reasonable cause, not willful neglect, and if the investment company pays a deductible tax equal to the excess of its nonqualifying gross income over 1/9 of the qualifying gross income (IRC Sections 851(i) and 852(b)(2)(G)).

6.53 50 percent test. At the end of each quarter of a RIC’s taxable year, at least 50 percent of the fair market value of the RIC’s total assets must be represented by cash and cash items (including receivables), U.S. government securities, securities of other RICs, and other securities. For this purpose, other securities do not include investments in the securities of any 1 issuer if they represent more than 5 percent of the fair market value of the investment company’s total assets or more than 10 percent of the issuer’s outstanding voting securities (except as provided in IRC Section 851[e]) (IRC Section 851(b)(3)(A)).

6.54 25 percent test. At the end of each quarter of a RIC’s taxable year, not more than 25 percent of the RIC’s total assets may comprise the securities of any 1 issuer, except for the securities of the U.S. government or other RICs. This requirement also prohibits investing more than 25 percent of the RIC’s total assets in 2 or more issuers that are controlled by the RIC and engaged in the same (or similar) or related trades or businesses (IRC Section 851(b)(3)(B)). For that purpose, the RIC controls the issuers if it has 20 percent or more of the combined voting power of each corporation (IRC Section 851(c)(2)). This requirement also prohibits investing more than 25 percent of the RIC’s total assets in 1 or more qualified PTPs, as defined in IRC Section 851(h) (IRC Section 851(b)(3)(B)).

6.55 For purposes of the diversification tests, the issuer of an option or futures contract is the corporation or government that issued the underlying security (Revenue Ruling 83-69, 1983-1 C.B. 126). For index instruments, the IRS has concluded in Private Letter Rulings and General Counsel Memoranda that the issuers of an option on a stock index are the issuers of the stocks or securities underlying the index, in proportion to the weighting of the stocks or securities in the computation of the index, regardless of whether the index is broad based or narrow based. The IRS has not issued “published” or “binding” guidance on the valuation of derivative instruments for purposes of this test.

6.56 A RIC that meets the asset diversification requirements at the end of the first taxable quarter of its existence will not lose its status as a RIC if it fails to satisfy those requirements in a later taxable quarter, provided that the noncompliance is due neither in whole nor in part to the acquisition of a security or other property. If a RIC fails to meet the diversification requirements because of an acquisition, it may reestablish its status for such taxable quarter end by eliminating the discrepancy between the diversification requirements and its holdings within 30 days after the end of the quarter using the securities’ values as of the end of the quarter (IRC Section 851(d)(1)). A RIC that fails to meet the diversification requirements will not be disqualified

a.     if the failure is due to the ownership of assets with a value that does not exceed the lesser of $10 million or 1 percent of total assets of the RIC at the end of the quarter, and the RIC disposes of assets or otherwise meets the diversification requirements within 6 months after the quarter in which the failure is identified; or

b.     if the failure is due to reasonable cause, not willful neglect, and the RIC notifies the IRS; files a list of the assets that caused the failure; pays a deductible tax equal to the greater of $50,000 or the highest corporate tax rate times the net income attributable to the identified assets during the period of failure; and disposes of the identified assets or otherwise complies with the diversification requirements within 6 months after the quarter in which the failure is identified or such other time period as specified in regulations (IRC Sections 851(d)(2) and 852(b)(2)(G)).

6.57 Special rules apply to an investment company that qualifies as a venture capital investment company (IRC Section 851(e)).

Variable Contracts

6.58 In addition to the diversification requirements applicable to all RICs (discussed in the previous paragraphs), special quarterly asset diversification tests are to be met by RICs used as investment vehicles for variable annuity, endowment, and life insurance contracts. The fund must meet these diversification requirements on a calendar-year basis without regard to the fund’s fiscal year (Treasury Regulation 1.817-5(c)(1)). In general, a segregated asset account will be considered adequately diversified if all of the following criteria from Treasury Regulation 1.817-5(b) are met:

a.     No more than 55 percent of total assets are represented by any 1 investment

b.     No more than 70 percent of total assets are represented by any 2 investments

c.     No more than 80 percent of total assets are represented by any 3 investments

d.     No more than 90 percent of total assets are represented by any 4 investments

In general, for a separate account to be permitted to look through to the assets of a RIC, all the interests in the RIC must be held by one or more insurance company separate accounts or other permissible entities identified in the Treasury regulations and other administrative guidance promulgated under IRC Section 817 (Treasury Regulation 1.817-5(f)(3) and Revenue Ruling 2007-58, 2007-2 C.B. 562).

6.59 All securities of the same issuer, all interests in the same real property project, and all interests in the same commodity are each treated as a single investment. Each governmental agency or instrumentality is treated as a separate issuer (Treasury Regulation 1.817-5(b)(1)(ii)).

6.60 The IRS regulations provide a safe harbor for segregated asset accounts. If the segregated asset account meets the safe harbor test, it will be deemed as being diversified. The safe harbor test is met if a segregated asset account meets the RIC diversification tests, and the segregated asset account has no more than 55 percent of the value of its total assets invested in cash, cash items, government securities, and securities of other RICs (IRC Section 817(h)(2)).

6.61 Special rules apply to a segregated asset account with respect to variable life insurance contracts (Treasury Regulation 1.817-5(b)(3)).

6.62 If the diversification test is not met on the last day of a particular quarter, the separate account is allowed a 30 day grace period after such quarter-end to meet the diversification requirements (Treasury Regulation 1.817-5(d)). An exception is also available for certain separate accounts that are in the start-up mode, whereby accounts are considered diversified for the first year of their existence (Treasury Regulation 1.817-5(c)(2)).

6.63 Failure of the underlying segregated asset accounts (separate accounts) to qualify will adversely affect the tax treatment of the variable annuity, endowment, or life insurance contracts (Treasury Regulation 1.817-5(a)(1)). It will not directly affect the tax status of the RIC. However, the auditor should consider the account’s compliance with the asset diversification requirements and, if the diversification test is not passed, the effect on financial statement disclosure.

Distribution Test

6.64 90 percent distribution test. A RIC must annually pay dividends (exclusive of capital gain dividends) at least equal to the sum of 90 percent of investment company taxable income and 90 percent of net tax-exempt income for the year. In addition, a corporation that has E&P from non-RIC years must distribute such E&P by the end of its first RIC year (IRC Section 852(a)(1)).

6.65 For purposes of this distribution test, a RIC may elect to treat as paid on the last day of the fiscal year all or part of any dividends declared after the end of its taxable year. Such dividends must be declared on or before the later of the 15th day of the 9th month following the close of the taxable year or the extended due date of the return for the taxable year. The dividends must be paid within 12 months after the end of the taxable year and not later than the first dividend payment of the same type of dividend after such declaration (IRC Section 855(a)).

6.66 If a RIC meets all the qualification tests and the 90 percent distribution test but does not distribute all its investment company taxable income, it must pay corporate income taxes on the undistributed portion (IRC Sections 852(b)(1) and 852(b)(3)(A)). Similarly, if the company fails to distribute its net capital gains it is subject to tax on any such undistributed gains.

6.67 A nondeductible excise tax on undistributed income is imposed on a RIC to the extent that the RIC does not satisfy certain distribution requirements for a calendar year (see the “Excise Tax on Undistributed Income” section beginning at paragraph 6.83).

6.68 Preferential dividends. For nonpublicly offered RICs, a dividends paid deduction is allowed only for distributions that are pro rata, with no preference regarding any share of stock compared with any other share of the same class of stock (IRC Section 562(c)). This rule has been repealed for RICs that are treated as publicly offered. A publicly offered RIC is any RIC, the shares of which are continuously offered pursuant to a public offering within the meaning of the Securities Act of 1933, regularly traded on an established securities market, or held by or for no fewer than 500 persons at all times during the taxable year (IRC Section 67(c)(2)(B)). For distributions subject to the preferential dividend rule, a RIC is considered to have only 1 class of stock if the only differences among the classes are expense allocations. However, certain class-specific expenses may be allocated to a particular class if the requirements of IRC Revenue Procedure 96-47 are met. Other expenses, such as advisory fees, must be allocated among all shares pro rata. IRC Revenue Procedure 99-40 provides guidance on waivers or reimbursements of expenses in a multiclass context.

6.69 A RIC must allocate the various kinds of dividends it pays (such as tax-exempt interest, net capital gains, or the dividends-received deduction) proportionately among the classes of stock outstanding if more than one class of stock exists (Revenue Ruling 89-81, 1989-1 C.B. 226).

6.70 Distributions made after December 31. For purposes of a dividend paid deduction for the RIC and income recognition for the shareholder, distributions declared in October, November, or December payable to shareholders of record in such months and actually paid during January of the following year must be treated as having been paid on December 31 of the previous year to the extent of E&P (IRC Section 852(b)(7)). This rule applies for both income and excise tax purposes.

6.71 A RIC may elect to treat as having been paid in the prior fiscal year (spillback or throwback) all or part of any dividends declared after the end of such taxable year (see paragraph 6.65). This election applies to regular dividends, capital gain dividends, and exempt-interest dividends. It affects only the RIC and does not change the year in which distributions are reported by the shareholders.

6.72 Deficiency dividends. A RIC may pay a deficiency dividend as a result of an increase in investment company taxable income, net capital gain, or a decrease in the deduction for dividends paid to protect its special status or avoid the imposition of entity-level federal income taxation (IRC Section 860(a)).

6.73 For taxable years beginning after December 22, 2010, a deficiency dividend is subject to an interest charge for the period from the due date of the return for the year of the deficiency dividend deduction to the filing of a claim for the deduction.

6.74 Equalization distributions. An open-end investment company may use equalization accounting to prevent changes in the per share equity in its undistributed net income that may be caused by the continuous issuance and redemption of shares. Equalization for tax purposes differs substantially from book equalization because the calculation ignores the impact of share subscriptions by purchasing shareholders (for example, gross equalization credits). See also paragraph 4.30 of this guide.

6.75 If a RIC is not considered a personal holding company, the RIC would be permitted to claim a dividends-paid deduction for the E&P associated with the redemption of shares (gross equalization debits) (Revenue Ruling 55-416, 1955-1 C.B. 416). Redeeming shareholders generally treat the entire redemption distribution as sales proceeds (IRC Section 302(b)(5)).

6.76 The treatment of equalization debits as a component of a RIC’s dividends-paid deduction is well established in the income tax rules (Treasury Regulation 1.562-1(b)(1)). However, the precise method of calculating the E&P attributable to the redeemed shares is not particularly clear. Management generally should consider the most recent IRS pronouncements if equalization debits are to be used.

6.77 Equalization debits used as dividends paid by a RIC may be used to satisfy the RIC’s regular distribution requirements and, also, the excise tax distribution requirements.

6.78 Capital gain dividends. A RIC may defer all or a portion of any post-October capital loss or late-year ordinary loss in determining the amount of the RIC’s capital gain dividends subject to reporting (IRC Sections 852(b)(3)(C) and (b)(8)). The impact of Notice 2015-41, “Capital Gain Distributions of Regulated Investment Companies,” should be considered, as the notice addresses how changes under the Regulated Investment Company Modernization Act of 2010 to IRC Section 852 affect the bifurcation adjustment in Notice 97-64 as well as the reporting and designation of capital gain dividends of RICs.

6.79 Elective deferral of late year losses. A RIC may elect to defer any portion of a qualified late-year ordinary loss to the first day of the following taxable year (IRC Section 852(b)(8)). A qualified late year-loss is defined as any post-October capital loss, and any late-year ordinary loss.

6.80 A post-October capital loss is

a.     any net capital loss attributable to the portion of the taxable year after October 31, or

b.     if there is no such loss —

i.     any net long-term capital loss attributable to such portion of the taxable year, or

ii.     any net short-term capital loss attributable to such portion of the taxable year.

6.81 A late-year ordinary loss is the net ordinary loss from the sale or other disposition of capital assets for the portion of the taxable year after October 31 (that is, a “specified loss” under IRC Section 4982(e)(5)) and other ordinary income or loss for the portion of the taxable year after December 31 (IRC Sections 852(b)(8)(F)).

6.82 The elective deferral of late year losses does not apply if a RIC’s taxable year ends in December (IRC Section 852(b)(8)(G)(ii)) and has made an election under 4982(e)(4). RICs with November year-ends who have made an election under 4982(e)(4) to use its fiscal year-end for computing capital gains and losses for excise tax purposes may not consider post-October capital losses or post-October specified losses in its calculation of its late year losses (IRC Section 852(b)(8)(G)(i)).

Excise Tax on Undistributed Income

6.83 Introduction. A nondeductible 4 percent entity-level excise tax on undistributed income is imposed on a RIC to the extent that the RIC does not satisfy certain distribution requirements for a calendar year (IRC Section 4982(a)) (as shown in the following paragraphs).

6.84 Measurement periods. To determine the excise tax, a RIC’s ordinary income and capital gain net income are measured separately.

6.85 Ordinary income generally equals the RIC’s investment company taxable income before the dividends paid deduction, determined using a calendar-year measurement period, excluding any gains or losses from the sale of capital assets. Ordinary gains or losses from the sale of capital assets after October 31 are generally treated as arising on January 1 of the following year (IRC Sections 4982(e)(1) and (e)(5)).

6.86 A RIC with a taxable year other than the calendar year may elect to treat a net ordinary loss for the portion of a taxable year ending on December 31 as arising on January 1 of the following calendar year for excise tax purposes (IRC Section 4982(e)(7)).

6.87 Capital gain net income is generally defined as the excess of gains over losses from sales or exchanges of capital assets measured using a one year period ending on October 31. This amount is reduced by net ordinary loss for the calendar year but not below net capital gain (IRC Section 4982(e)(2)). In other words, net ordinary losses can be offset against net short-term capital gains but not against net long-term gains.

6.88 RICs with fiscal years ending in November or December may elect to determine their capital gain net income as of the end of that fiscal year (IRC Section 4982(e)(4)).

6.89 Calculation and elections. No excise tax is imposed if the RIC makes sufficient distributions during each calendar year at least equal to the sum of the following:

a.     98 percent of the ordinary income for the calendar year

b.     98.2 percent of the capital gain net income for the one year period ending on October 31

c.     100 percent of the ordinary income or capital gain net income of the prior year that was not previously distributed (IRC Section 4982(b))

6.90 Provided that a RIC distributes in the aggregate an amount at least equal to the sum of the amounts listed previously, the excise distribution requirement will be satisfied.

6.91 Any overdistribution (other than that attributable to a return of capital) from the prior year may be applied to the required distribution of the current year (IRC Section 4982(c)(2)).

6.92 If a RIC retains a portion of its taxable income or gains and pays income tax on that amount, the amount will be treated as distributed for excise tax purposes. A RIC may treat payments of estimated income tax as distributed for excise tax purposes (IRC Section 4982(c)(4)). If a RIC distributes less than the minimum excise requirement, the RIC will be subject to a 4 percent excise tax on the difference between the RIC’s minimum annual distribution requirement and the amount actually distributed by the RIC and include 100 percent of such amount on which the excise tax was imposed in the calculation of required distributions in the subsequent year (IRC Section 4982(c)(1)).

6.93 RIC feeder funds generally include their ratable amounts of all items of income, gain, and loss earned by a master fund organized as a partnership in which it invests for the excise tax periods described in paragraphs 6.87–.88.⁸ This contrasts with a RIC maintaining an equity interest in a partnership outside the master-feeder structure. In the latter case, partnership income is generally included in the measurement period that includes the year-end of the partnership (Revenue Procedure 94-71, 1992-2 C.B. 810).

6.94 In determining a RIC’s required excise tax distribution, foreign currency gains or losses from Section 988 transactions, the mark-to-market rules for Section 1256 contracts and Section 1296 passive foreign investment company (PFIC) stock, and other provisions which treat property as disposed of or by reference to a value on the last day of the taxable year are applied using October 31 as a year-end (or November 30 or December 31 if a fiscal year election is made).⁹ Capital loss carryovers computed using the excise tax measuring period may be used to reduce capital gain net income for purposes of the excise tax.¹⁰ Capital gain net income may be reduced (but not below net capital gain) by the RIC’s ordinary loss for the calendar year (IRC Section 4982(e)(2)(B)).

6.95 Exemption for certain RICs. Excise tax rules do not apply to a RIC if, at all times during a calendar year, each shareholder was a qualified pension trust or segregated asset account of a life insurance company held in connection with variable contracts. Shares owned by the investment adviser attributable to the seed money it contributed (up to $250,000) are not counted for this purpose (IRC Section 4982(f)). RICs that are wholly owned by other exempt entities or other RICs that qualify for this exemption are also exempt from the excise tax rules.

Computation of Taxable Income and Gains

6.96 Dividends and interest. RICs record dividend income on the ex-dividend date for tax and accounting purposes (IRC Section 852(b)(9)).

6.97 If a dividend or other distribution received by a RIC represents a return of capital, the basis of the security from which such distribution is made is reduced for tax purposes. If the distribution exceeds the RIC’s tax basis in the security, the excess is treated as capital gain (IRC Section 301(c)).

6.98 Interest and original issue discount (OID) are accrued on a daily basis for tax and accounting purposes. However, differences in book and tax accounting for interest and OID related to complex securities and troubled debt securities may exist. See appendix D, “Computation of Tax Amortization of Original Issue Discount, Market Discount, and Premium,” for more information.

6.99 Sales of securities. The basis of securities sold or otherwise disposed of may be either identified specifically or determined following a first in first out convention; average cost for tax purposes only may be used for RIC shares and certain shares acquired in connection with a dividend reinvestment plan. Identification procedures are prescribed in regulations (Treasury Regulation 1.1012-1(c)(1)).

6.100 Under the IRC, a wash sale occurs on a sale of securities (including options) if the seller acquires or enters a contract or an option to acquire substantially identical securities within a period beginning 30 days before the date of a sale at a loss and ending 30 days after such date (61-day period) (IRC Section 1091). A loss resulting from such a transaction is deferred for tax purposes; the amount of the loss increases the tax basis of the new security purchased, and the holding period of the new position includes the holding period of the original position (IRC Sections 1091(b),(c), and (d) and 1223(3)). However, a gain on the same type of transaction is taxable, and the tax basis of the new security is not affected by the sale of the old security. Wash sale rules also apply to short-sale transactions such that the date that a short sale is made, rather than the date of close, is considered in determining whether a wash sale has occurred (Treasury Regulation 1.1091-1(g)).

6.101 Commissions. Commissions related to purchases or sales of securities are not deductible but are added to the basis of the securities or offset against the selling price (Treasury Regulation 1.263(a)-2(e)).

6.102 Bond discount and premium. Special, detailed rules prescribe the calculation and treatment of discount and premium on taxable and tax-exempt securities. Although a discussion of these rules is beyond the scope of this guide, the auditor should consider the application of these rules and how they affect the recognition and characterization of income and the deductibility of interest expense for tax purposes. See appendix D of this guide for more information.

6.103 Section 1256 contracts. Certain financial instruments (Section 1256 contracts) held by a RIC may be subject to mark-to-market rules. Section 1256 contracts include any regulated futures contracts, foreign currency contract, nonequity option, dealer equity option, and dealer securities futures contract. Under these detailed rules, a RIC is treated for tax purposes as selling any Section 1256 contract held on the last day of its taxable year for its fair market value. Gain or loss on an actual or deemed disposition of a Section 1256 contract is treated as 40 percent short term capital gain or loss and 60 percent long term capital gain or loss, regardless of the holding period for the Section 1256 contract (IRC Section 1256). A detailed discussion of these rules is beyond the scope of this guide.

6.104 Tax straddles. The term straddle describes offsetting positions in personal property in which the fair market value of each position is expected to fluctuate inversely to that of the other. The term position means an interest (including a futures or forward contract or option) in personal property. An offsetting position occurs whenever risk of loss has been substantially diminished by holding one or more other positions (IRC Section 1092(c)).

6.105 The straddle rules provide that a loss from any position should be recognized only to the extent that such loss exceeds the unrecognized gain with respect to one or more offsetting positions or successor positions or positions that are offsetting to successor positions. Although a detailed discussion of the straddle rules is beyond the scope of this guide, it is important to note that funds that engage in hedging may have significant book versus tax differences in capital gains or losses as a result of the straddle rules.

6.106 Stock issuance costs. Stock issuance costs paid by an open-end investment company are deductible for tax purposes, except costs incurred during the initial stock offering period. This also applies to 12b-1 fees (Revenue Rulings 73-463 and 94-70). Stock distribution costs of a closed-end investment company that redeems shares quarterly (an “interval fund”) are also deductible. Registration fees and expenses, including accounting procedures, are discussed in further detail in chapter 8, “Other Accounts and Considerations,” of this guide.

6.107 Stock redemption costs. Only stock redemption costs of an open-end investment company, not a closed-end investment company, are deductible in computing investment company taxable income (IRC Section 162(k)(2)(B)).

6.108 Limitations on tax benefits of losses. A 50 percent change of ownership, taking into account only 5 percent shareholders, within a 3-year period, whether through a reorganization or in the ordinary course of business, may limit the tax benefits of losses realized or unrealized before the ownership change in periods after the ownership change. The annual limit on such losses is generally the net fair market value of the assets of the RIC that has experienced the ownership change, multiplied by a long term tax-exempt interest rate on the date of the ownership change (IRC Sections 381–384).

6.109 Section 988 transactions. Special rules apply to the treatment of foreign currency gains and losses attributable to Section 988 transactions. Foreign currency gains and losses from such transactions are characterized as U.S.-source ordinary income or loss (IRC Section 988(a)).

6.110 A foreign currency gain or loss will result from a Section 988 transaction, described as follows, denominated in a currency other than the RIC’s functional currency (nonfunctional currency) or the fair value of which is determined by reference to nonfunctional currency:

a.     Acquiring a debt instrument or becoming the obligor under a debt instrument

b.     Accruing any item of expense or gross income or receipt that is to be paid or received at a later date

c.     Entering or acquiring any forward contract, futures contract, option, or similar financial instrument

d.     Disposing of any nonfunctional currency (IRC Section 988(c)(1))

6.111 The functional currency of a RIC is the currency of the economic environment in which the RIC’s operations are predominantly conducted and the currency used in keeping its books and records. The functional currency of a RIC is generally the U.S. dollar. Certain single-country funds may have a functional currency other than the dollar (IRC Section 985(b) and example 2 of Treasury Regulation 1.985-1(f)).

6.112 Interest income or expense (including OID and discounts on certain short term obligations) on a nonfunctional currency debt instrument is determined in units of nonfunctional currency and translated into functional currency at the average exchange rate for the accrual period for accrual-basis RICs (Treasury Regulation 1.988-2(b)(2)).

6.113 Foreign currency gain realized on the disposition of a Section 988 debt security will be recognized for tax purposes and treated as U.S.-source ordinary income to the extent of the lesser of the foreign currency gain or the overall gain realized. Similarly, if a foreign currency loss is realized in a Section 988 transaction, it will be recognized for tax purposes and treated as a U.S.-source ordinary loss to the extent of the lesser of foreign currency loss or the overall loss realized (IRC Section 988(b)).

6.114 The acquisition of nonfunctional currency is treated as an acquisition of property (Treasury Regulation 1.988-1(a)) with a functional currency tax basis determined with reference to the spot contract exchange rate (spot rate). A spot contract is a contract to buy or sell nonfunctional currency on or before two business days following the date of the execution of the contract (Treasury Regulation 1.988-1(b)). The disposition or other use of nonfunctional currency will result in a Section 988 transaction if it is exchanged for another nonfunctional currency or functional currency (Treasury Regulation 1.988-2(a)).

6.115 Although Section 988 does not apply to transactions involving equity securities, any fluctuation in the exchange rate between the trade date and settlement date of either a purchase or sale of an equity security will result in a foreign currency gain or loss because the payment of the settlement liability constitutes a Section 988 transaction (Treasury Regulation 1.988-2(a)(2)).

6.116 The sale, closing, or settlement (including by taking or making delivery of currency) of any forward contract, futures contract, option, or other similar financial instrument denominated in (or the fair market value of which is determined by reference to) a nonfunctional currency results in ordinary income or loss, unless the contract is a futures or listed option contract traded on a qualified board or exchange (Treasury Regulation 1.988-2(a)). However, certain elections are available for these kinds of financial instruments that permit income or gain to be characterized differently. A detailed discussion of these rules is beyond the scope of this guide.

6.117 The IRS has provided special rules for certain Section 988(d) hedging transactions. Current regulations cover certain debt instruments, the currency risk (or a portion thereof) of which is entirely eliminated through a qualified hedge; executory contracts that are hedged; and hedges of trade to settlement date receivables and payables arising due to the sale or purchase of stocks or securities traded on an established securities market. These regulations provide integrated treatment for Section 988(d) hedging transactions. The IRS may also issue rulings to taxpayers regarding net hedging and anticipatory hedging methods (Treasury Regulation 1.988-5).

6.118 The timing of the recognition of gain or loss from contracts subject to both Sections 988 and 1256 is governed by the rules of Section 1256 (Treasury Regulation 1.988-2(d)). Such contracts, therefore, are marked to market at fiscal year-end. The character of such gain or loss may be either ordinary or capital, depending upon the kind of contract and whether certain elections are made.

6.119 Passive foreign investment companies. If a RIC owns equity securities of a corporation that is determined to be a PFIC for U.S. tax purposes, the RIC may be subject to an entity-level interest charge on excess distributions received from the PFIC, including gains realized on the sale or other disposition of such PFIC’s shares. This is true even if the RIC has met its distribution requirements for the taxable year in which such excess distribution is deemed to have occurred.

6.120 The intent of the PFIC legislation was to prevent U.S. taxpayers from deferring taxes by acquiring equity securities of foreign investment companies, which are not subject to U.S. income tax and do not pay dividends currently. The PFIC rules effectively result in the recognition of taxable income by U.S. taxpayers that would be consistent with a situation as if the foreign company made a taxable distribution of all its income and appreciation each year.

6.121 A foreign corporation is a PFIC for a taxable year if 75 percent or more of the corporation’s gross income is passive income or if 50 percent or more of the foreign corporation’s assets produce (or are held for the production of) passive income (IRC Section 1297(a)). Passive income includes dividends, interest, royalties, rents, annuities, and net gains from the sale of securities; foreign currency; and certain commodity transactions that are not realized from an active trade or business engaged in by the PFIC (IRC Section 1297(b)). Examples of passive assets include cash (even if maintained for working capital requirements), stocks, bonds, and other securities held by the PFIC.

6.122 A RIC that owns a PFIC’s equity securities may be able to avoid the imposition of a RIC-level interest charge if the RIC elects to treat the PFIC as a qualified electing fund (QEF) (IRC Section 1295). The RIC’s share of the PFIC’s ordinary income and capital gain each year are included as taxable income if the election is made (IRC Section 1293(a)). The earnings of the QEF must be determined based on U.S. tax principles making it difficult for many foreign corporations to provide the necessary information.

6.123 A RIC may alternatively elect to mark its PFIC shares to market at the close of the RIC’s taxable year, as well as on October 31, and treat increases in unrealized appreciation (and decreases to the extent that increases have been included previously in taxable income) as part of the RIC’s taxable income and required excise tax distribution (IRC Sections 1296 and 4982(e)(6)).

6.124 Both the QEF and mark-to-market elections may result in the RIC having to make distributions of income that it has not yet received.

6.125 A failure to make either of these elections may subject the RIC to an entity-level interest charge, in which case the recording of a tax liability generally should be considered.¹¹ Thus, it is important to determine that RICs holding foreign securities have policies and procedures to identify PFICs timely.

Offshore Funds

6.126 In recent years, the number of funds that are organized outside the United States (offshore funds) has increased substantially. This has occurred as U.S. fund advisers sought to globalize their customer base and as foreign institutions increased their investments in U.S. securities.

6.127 A myriad of U.S. and foreign tax issues are associated with offshore funds. These funds are typically organized in the form that is most suitable for the expected owners. Further, they are located in the jurisdiction that provides the most beneficial taxation and regulation of the entity, taxation of owners, and withholding tax treatment for income earned and distributions made.

6.128 Offshore funds are usually not subject to income taxes imposed by the country in which they are domiciled. However, they are generally subject to U.S. withholding tax on dividends from U.S. stock holdings. They are not generally subject to entity-level U.S. income taxation, provided that they are structured in such a way that they are not considered engaged in a U.S. trade or business for U.S. tax purposes (Treasury Regulation 1.864-2).

6.129 Consideration of both U.S. and local country tax and regulatory regimes is necessary for each offshore fund due to those regimes’ often complex nature. Because an investment company must be organized in the United States in order to qualify as a RIC, an offshore fund subject to U.S. tax cannot elect to be treated as a RIC.

6.130 Management of offshore funds generally should have tax policies and procedures addressing the taxation of the fund in the offshore country in which the fund is domiciled, the taxation of the fund’s portfolio securities in the country in which the securities are taxed, and the taxation of fund shareholders in the countries in which they reside.

Small Business Investment Companies

6.131 Small business investment companies (SBICs) formed as corporations are generally subject to the corporate tax rules, unless they qualify and elect to be treated as RICs. SBICs also may be structured either as partnerships or disregarded as entities separate from their owners.

6.132 An SBIC organized as a corporation and operating under the Small Business Investment Act of 1958 (SBIA), receives special tax treatment. It is allowed a 100 percent deduction for dividends received that qualify for the dividend received deduction, unless it elects to be taxed as a RIC (IRC Section 243(a)(2)). In addition, the SBIC may be excluded from the definition of a personal holding company (IRC Section 542(c)(7)).

6.133 A shareholder in an SBIC operating under the SBIA may characterize a loss on its stock as an ordinary loss. In computing the net operating loss deduction, such a loss is treated as a loss from a trade or business (IRC Section 1242).

6.134 The tax rules permit special treatment for investors, including investment companies, in SBICs other than those licensed under the SBIA. Investors in small business corporations may qualify for ordinary loss treatment on the sale of their shares (IRC Section 1244). Investors in qualified small business stock may qualify for a 50 percent exclusion from gross income on the sale of small business stock (IRC Section 1202).