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Congress Passes Legislation Modernizing Federal Tax Code Treatment of SEC-Regulated Investment Companies

By Jim Hamilton

Congress has passed bi-partisan legislation modifying and updating federal tax code provisions pertaining to SEC-regulated investment companies in order to make them better conform to, and interact with, other aspects of the tax code and applicable federal securities laws. The Regulated Investment Company Modernization Act, HR 4337, would reduce the burden arising from amended year-end tax information statements, improve a mutual fund's ability to meet its distribution requirements, create remedies for inadvertent mutual find qualification failures, improve the tax treatment of investing in a fund-of-funds structure, and update the tax treatment of fund capital losses. The legislation applies to taxable years beginning after the date of enactment.

An SEC-regulated investment company must derive 90 percent of its gross income for a taxable year from certain types of income, called qualifying income, which includes gains from the sale or other disposition of stock or securities as defined in Section 2(a)(36) of the Investment Company Act or foreign currencies, or other income derived with respect to the business of investing in such stock, securities, or currencies. In general, because direct investments in commodities are not securities under Section 2(a)(36)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.

The original House version of HR 4337 would have changed the qualifying income test to provide that gains from the sale or other disposition of commodities are qualifying income for purposes of the gross income test. As a result, income earned by an investment company from derivative contracts with respect to commodity indices would have been qualifying income. However an amendment offered by Senator Jeff Bingaman (D-NM), and approved by the Senate, stripped out this provision. The HOuse agreed to the Bingaman Amendment and sent the bill to the President, who is expected to sign it.

The legislation would modernize federal tax code provisions governing mutual funds that have not been updated in any meaningful or comprehensive way since the adoption of the Internal Revenue Code of 1986, and some of the provisions date back more than 60 years. Numerous developments during the past two decades, including the development of new fund structures and distribution channels, have placed considerable stress on the current tax code sections.

In general, regulated investment companies under the Code are domestic corporations
that either meet or are excepted from SEC registration requirements under the Investment
Company Act, that derive at least 90 percent of their ordinary income from passive investment income, and that have a portfolio of investments that meet certain diversification requirements. Regulated investment companies under the Code can be either open-end companies (mutual funds) or closed-end companies.

The legislation would allow funds an unlimited carryforward of their net capital losses; limit penalties for failure of funds to satisfy gross income and asset tests; modify rules for allocating fund capital gain dividend distributions; allow funds that invest exclusively in the shares of other funds to pass through to their shareholders tax-exempt interest and foreign tax credits, without regard to certain investment limitations; modify rules relating to the declaration of fund dividends, return of capital distributions, and stock redemptions; allow funds with shares that are redeemable upon demand to treat distributions in redemption of stock as an exchange of fund shares or a dividend for tax purposes; allow a deferral of end-of-year losses of funds; and modify excise tax and penalty rules.

The incoming Chair of the House Ways and Means Committee, Rep. Dave Camp (R-Michigan) strongly supports the complete legislative overhaul of federal tax code provisions affecting investment companies. Specifically, Rep. Camp, who was a manager of the Regulated Investment Company Modernization Act, HR 4337, said that the legislation would modernize federal tax code provisions governing mutual funds that have not been updated in any meaningful or comprehensive way since the adoption of the Internal Revenue Code of 1986, and some of the provisions date back more than 60 years. Noting that he is not aware of any controversy or opposition to the legislation, Rep. Camp broadly emphasized that it is entirely appropriate for Ways and Means to periodically review the tax law to ensure that targeted provisions of importance to particular segments of the economy, including the mutual fund industry and their investors, are kept up to date. (Cong. Record, Sept. 28, 2010, H7069-7070).

The legislation provides capital loss carryover treatment for investment companies similar to the current Code treatment of net capital loss carryovers applicable to individuals. Under the Act, if a fund has a net capital loss for a taxable year, the excess of the net short-term capital loss over the net long-term capital gain is treated as a short-term capital loss arising on the first day of the next taxable year, and the excess of the net long-term capital loss over the net short-term capital gain is treated as a long-term capital loss arising on the first day of the next taxable year. The number of taxable years that a net capital loss of an investment company may be carried over under the provision is not limited.

The legislation provides for the treatment of net capital loss carryovers under the present Code rules to taxable years of a fund beginning after the date of enactment. These rules apply to capital loss carryovers from taxable years beginning on or before the date of enactment of the provision and capital loss carryovers from other taxable years prior to the taxable year the corporation becoming an SEC-regulated investment company.

Amounts treated as a long-term or short-term capital loss arising on the first day of the next taxable year under the provision are determined without regard to amounts treated as a short-term capital loss under the present-law carryover rule. In determining the amount by which a present-law carryover is reduced by capital gain net income for a prior taxable year, any capital loss treated as arising on the first day of the prior taxable year under the provision is taken into account in determining capital gain net income for the prior year.

The legislation, in Section 301, replaces the present-law designation requirement for a capital gain dividend with a requirement that a capital gain dividend be reported by the fund in written statements furnished to its shareholders. A written statement furnishing this information to a shareholder may be a Form 1099.

The legislation provides a special rule allocating the excess reported amount for taxable year funds in order to reduce the need to amend Form 1099s and shareholders to file amended income tax returns. This special allocation rule applies to a taxable year of a fund which includes more than one calendar year if the fund?s post-December reported amount exceeds the excess reported amount for the taxable year.

Section 303 says that a qualified fund of funds may pay exempt-interest dividends without regard to the requirement that at least 50 percent of the value of its total assets consist of tax-exempt state and local bonds and elect to allow its shareholders the foreign tax credit without regard to the requirement that more than 50 percent of the value of its total assets consist of stock or securities in foreign corporations. For this purpose, the Act defines a qualified fund of funds to mean a fund at least 50 percent of the value of the total assets of which, at the close of each quarter of the taxable year, is represented by interests in other funds.

The legislation provides that, in the case of a non-calendar year fund which makes distributions of property with respect to the taxable year in an amount in excess of the current and accumulated and earnings and profits, the current earnings and profits are allocated first to distributions made on or before December 31 of the taxable year. Thus, under Section 305 of the Act, in the above example, all $3 million of the distribution made on September 15 is out of current earnings and profits and thus treated as dividend income.

Section 306, provides that, except to the extent provided in regulations, the redemption of stock of a publicly offered fund is treated as an exchange if the redemption is upon the demand of the shareholder and the company issues only stock which is redeemable upon the demand of the shareholder. A publicly offered fund is a fund the shares of which are continuously offered pursuant to a public offering, regularly traded on an established securities market, or held by no fewer than 500 persons at all times during the taxable year.

Full post as published by Jim Hamilton's World of Securities Regulation on December 16, 2010 (boomark / email).