ICI Suggests Items for Inclusion on Priority Guidance Plan

June 7, 2019

David Kautter
Assistant Secretary (Tax Policy)
U.S. Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Michael J. Desmond
Chief Counsel
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

RE: Guidance Priority List Recommendations

Dear Mr. Kautter and Mr. Desmond:

The Investment Company Institute¹ recommends the following issues affecting regulated investment companies (RICs) and their shareholders for inclusion on the 2019-2020 Guidance Priority List.² As requested in Notice 2019-30, these recommendations have been listed in order of priority. The Institute notes, however, that there are many outstanding issues that are important to the industry; additional items that have been included in prior requests for guidance from the Department of the Treasury (Treasury Department) and Internal Revenue Service (IRS) are included below as Enclosure A.

I. Guidance to Implement 2017 Tax Law Changes

We appreciate that the Treasury Department and IRS have focused their efforts on guidance projects necessary to implement the 2017 tax law changes (Pub. L. No. 115-77 (commonly referred to as the Tax Cuts and Jobs Act (TCJA)). Many of our recommendations related to implementation of the TCJA have been addressed in the form of a notice or proposed regulations. We urge the Treasury Department and IRS to issue or finalize such guidance in a timely manner.

A. Pass-Through of Section 199A Deduction to RIC Shareholders

The Institute and its members welcomed the proposed regulations under section 199A regarding investments in real estate investment trusts (REITs) by regulated investment companies (RICs).³ The proposed regulations confirm that RICS may pass through to RIC shareholders qualified dividends from REITS so that RIC shareholders can take the 20 percent deduction under section 199A. We believe that the proposed regulations appropriately implement Congress' intent under the authority granted to the Treasury Department and the IRS in sections 7805(a) and 199A(f)(4)⁴ and urge that they be finalized.

B. Section 451(b)

The Treasury Department and IRS in Notice 2018-80 announced their intention to issue proposed regulations providing that accrued market discount is not includible in income under section 451(b). We urge the Treasury Department and IRS to issue such proposed regulations.

The Institute remains concerned about the scope of section 451(b) as it applies to the accrual of original issue discount (OID).⁵ In some cases, the resulting timing differences may be significant; in others, the differences may be minor, and any potential benefit to the government would be far outweighed by the compliance burden that RICs would bear. More specifically, the Institute urges the Treasury Department and IRS to confirm that amended section 451(b) applies to OID only with respect to items, such as certain fees, that are treated as something other than discount under Generally Accepted Accounting Principles (GAAP).

C. Section 163(j) Interest Expense Limitation

The guidance issued in Notice 2018-28 and the subsequent proposed regulations were helpful in clarifying the application of section 163(j) to RICs.⁶ The proposed regulations confirm that all of a RIC's income, gains, deductions or losses are included in calculating the RIC's adjusted taxable income for purposes of determining the interest expense limitation. The proposed regulations also clarify that a RIC's adjusted taxable income for purposes of the new limitation is determined before the application of the dividends paid deduction (DPD) under section 561. We urge the Treasury Department and IRS to finalize this RIC guidance promptly.

We also request that the Treasury Department and IRS provide guidance confirming that interest-related dividends paid by RICs are interest when received by corporate shareholders for purposes of determining such corporation's interest expense limitation under section 163(j). Absent such guidance, the interest expense limitation for corporate shareholders in fixed income or money market funds could be inappropriately limited to 30 percent of the amount received instead of a full dollar-for-dollar offset as intended under the rules.

II. UMBS TBA Contracts and Diversification under Section 817(h)

The Institute requests that the Treasury Department and IRS issue further guidance regarding diversification testing of To-Be-Announced (TBA) contracts for Uniform Mortgage Backed Securities (UMBS) for purposes of section 817(h). As outlined in our letters,⁷ the guidance in Rev. Proc. 2018-54 does not address the critical question of how to test TBA contracts for UMBS.

We ask that the government issue guidance permitting taxpayers to choose either to (1) apply the deemed issuance ratio to UMBS TBA contracts or (2) treat the counterparty as the issuer, solely for purposes of section 817(h). Such guidance would provide taxpayers with certainty regarding the treatment of the UMBS TBA contracts without implicating the treatment of other contracts for this and other purposes. The current lack of certainty will affect negatively our members' ability to successfully manage and advise investment funds and managed accounts. Indeed, because UMBS have begun trading in the TBA market, we understand that the lack of guidance already is having an impact.

We also recommend that the guidance be issued as a safe harbor rather than as an affirmative election. Further, we recommend that the Treasury Department and IRS similarly amend the guidance in Rev. Proc. 2018-54 to provide for a safe harbor. Finally, we request clarification as to the identity of the “taxpayer” for purposes of this guidance.

III. Check-the-Box Election

The Institute urges the Treasury Department and IRS to issue guidance to coordinate the entity classification election under the check-the-box regulations⁸ with the RIC election under section 851(b)(1). Specifically, we request that an eligible entity electing to be treated as a RIC will be deemed to have elected to be classified as an association taxable as a corporation, effective as of the first day the entity is treated as a RIC.⁹ The regulations already provide such a deemed check-the-box election for entities that elect to be treated as REITs, for certain entities claiming tax-exempt status, and for entities electing to be taxable as S corporations. Amending the regulations to similarly coordinate the RIC election with the check-the-box rules will reduce administrative burdens for affected entities and the IRS and provide certainty as to an entity's status.

IV. Taxable Mortgage Pools

The Institute renews its request for regulatory guidance to clarify issues relating to excess inclusion income of a REIT that is a taxable mortgage pool (TMP) or that has a qualified REIT subsidiary that is a TMP. The renewed urgency for this guidance is due to certain RICs owning REITs in the Russell 2000 Index that reported a portion of their 2018 dividends as excess inclusion income for federal income tax purposes.¹⁰ Although Notice 2006-97¹¹ addressed a few issues, and responded to some of the Institute's concerns regarding the lack of guidance in this area,¹² many critically important issues remain unresolved. At a minimum, and as requested by the Institute in 2006, guidance should be issued stating that Notice 2006-97 will not be applied until some reasonable period after a practical reporting regime is implemented and the many uncertainties arising from the Notice are resolved.¹³

V. Qualified Interest Income

The Institute appreciates that the Treasury Department and IRS have issued guidance over the past few years to address the newly applicable SEC money market rules and prevent tax considerations from undermining a RIC's ability to meet them. One last issue arising from the resulting increased demand for government securities, however, must be addressed for these RICs to remain attractive for foreign investors.

Specifically, RICs are being forced by the increased demand for government securities to gain this exposure through repurchase agreements (repos) on government securities. Disparities in banking regulations, however, are causing banks to conduct their repo business through foreign branches that, as a general matter, result in “foreign source” income.

For government money market funds to make distributions that are fully exempt from US withholding tax as qualified interest income (QII) when paid to foreign investors, the income must have a US source. US tax is problematic for foreign investors using money market funds for cash management purposes, particularly when non-US alternatives are available.

The Institute therefore requests guidance that amounts received on repos, that are collateralized solely by US government securities (as that term is applied under Subchapter M), will be treated as US source income in determining QII under Code section 871(k)(1)(E).¹⁴

VI. Foreign Tax Recoveries from European Union Member States under Santander

The Institute urges the IRS to issue guidance standardizing the terms of any closing agreement necessary to address situations not covered by Notice 2016-10; this Notice, as you may know, provides an administrable solution for the US fund industry's receipt of withholding tax refunds following the European Court of Justice (ECJ) decisions in Santander¹⁵ and DFA Emerging Markets.¹⁶ Specifically, we urge a uniform methodology for calculating the “compliance fee” that balances appropriately the relevant administrative and fairness considerations. We also reiterate our proposals in previous letters¹⁷ that RICs be permitted to use netting even when netting can be achieved only by carrying forward excess tax recoveries for some limited number of years.

VII. Money Market Fund Reform

The Treasury Department and IRS have addressed most of the issues arising from money market reform. In addition to the QII issue discussed above, we request guidance on two remaining issues.¹⁸ First, we ask the IRS and Treasury Department to provide guidance on how funds should treat any liquidity fees received. Second, the government should clarify whether the distribution of excess liquidity fees results in a return of capital or if the fund is deemed to have sufficient earnings and profits to support such distribution.

VIII. FATCA

The Institute strongly supports FATCA's tax compliance objectives and welcomed the recent proposed regulations to eliminate withholding on gross proceeds, defer withholding on foreign passthru payments, and clarify the definition of investment entity. We urge the Treasury Department and IRS to finalize the proposed regulations.

The Institute encourages the continued refinement of administrable rules that implement, consistent with Congressional intent, the Chapter 4 reporting and withholding regime. Consistent with prior submissions, the Institute recommends that the IRS and Treasury Department (1) clarify the Form 1042-S coding for long-term capital gain dividends, (2) improve the interaction of Forms 1042-S and W-8, and (3) smooth the transition to the new W-8 series forms.¹⁹ As FATCA's phased implementation is well underway, the Institute recommends giving FATCA issues continued high priority.

* * *

If we can provide you with any additional information regarding these issues, please contact Keith Lawson (202-326-5832 or lawson@ici.org), Karen Gibian (202-371-5431 or kgibian@ici.org) or me (202-326-5826 or katie.sunderland@ici.org).

Sincerely,

Katie Sunderland
Assistant General Counsel — Tax Law
Investment Company Institute
Washington, DC

cc:
Notice.comments@irscounsel.treas.gov
Peter Blessing
Scott Dinwiddie
Chip Harter
Helen Hubbard
Michael Novey
William Paul
Doug Poms
John Sweeny
Drita Tonuzi
Krishna Vallabhaneni
Robert H. Wellen

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Enclosure A: Additional Recommendations for the 2019-2020 Guidance Priority List

I. Issues on the 2018-2019 Guidance Priority List

The Institute requests that the Treasury Department and IRS issue guidance on the following items currently on the 2018-2019 Guidance Priority List.

A. PFICs

We ask the Treasury Department and IRS to issue additional guidance regarding passive foreign investment companies (PFICs). The preamble to the final PFIC mark-to-market regulations²⁰ notes in three places that comments received relating to the impact of the PFIC rules on RICs were beyond the scope of that regulations project.²¹ We request that a regulations project be opened to address these and other PFIC-related issues faced by the industry.

Specifically, the Institute requests guidance providing (i) that gains from dispositions of former PFIC stock are capital while losses are ordinary to the extent of prior unreversed inclusions; (ii) RICs with automatic consent to terminate a section 1296 election during a non-PFIC year; (iii) that RICs may recognize any change in PFIC status of a foreign corporation for the RIC's taxable year within which the taxable year of the foreign corporation ends; (iv) that the consequences to RICs of applying former Prop. Treas. Reg. § 1.1291-8 will be respected, where relevant, for purposes of section 1296; and (v) that RICs may determine qualified electing fund (QEF) inclusions using audited financial statements that were prepared using U.S. Generally Accepted Accounting Principles (GAAP) or International Financial Reporting standards, and that all QEF inclusions subject to this election will be treated as ordinary, but retain the capital character of disposition gains and losses.

B. Guidance on Income and Asset Diversification

The Institute recommends that the Treasury Department and IRS provide guidance regarding the application of the “cure” provisions in Code Sections 851(d)(2) and (i), added by the Regulated Investment Company Modernization Act,²² including the schedules referred to in Sections 851(d)(2)(A)(i) and (i)(1)(A) and the meaning of “due to reasonable cause and not due to willful neglect” in Sections 851(d)(2)(A)(ii) and (i)(1)(B). Specifically, the Institute requests that the IRS provide guidance allowing RICs to rely on the REIT regulations²³ for purposes of the RIC income test. The Institute also requests that the IRS provide guidance regarding the asset diversification cure provisions for RICs.

C. Section 529 Qualified Tuition Programs

The Institute commends the Treasury Department and IRS for releasing Notice 2018-58 announcing its intention to issue regulations clarifying matters relating to the administration of amounts recontributed to section 529 plans.²⁴ Specifically, the Notice provides that the entire recontributed amount will be treated as principal, rather than requiring a portion to be treated as earnings, based on the amount that represented earnings when distributed. The Notice explains that it is implementing this rule of administrative convenience to eliminate the burdens associated with determining the earnings portion. It also confirms that the recontributed amount will not count against the contribution limit applicable to the beneficiary, because the amount will already have been taken into account when it was originally contributed to the 529 plan. We urge the Treasury Department and IRS to issue such regulations.

In addition, a project to address section 529 plan issues, which was included on prior Guidance Priority Lists, was deleted from the 2009-2010 list without guidance being issued. Guidance regarding section 529 plans remains necessary to implement fully the Advance Notice of Proposed Rulemaking (“Advance Notice”) regarding section 529 plans that the IRS released in 2008. We are pleased that the Advance Notice reflects several comments previously submitted jointly by the Institute and the Securities Industry and Financial Markets Association (“SIFMA”).²⁵ It remains important, for those saving for education through section 529 plans, that the tax treatment of investments in such plans is clear. We urge the IRS to continue its work on this guidance project to address outstanding issues.²⁶

II. Outstanding Issues on Previous Years' Requests for Guidance

The Institute requests that the Treasury Department and IRS issue guidance on the following items which have been included in the Institute's previous requests for guidance.

A. Items Related to RIC Modernization Act of 2010

The Institute continues to seek regulatory guidance necessary to properly implement the provisions of the RIC Modernization Act of 2010 (the RIC Modernization Act).²⁷

First, we request guidance allowing a RIC to meet the RIC Modernization Act's requirement to provide its shareholders with a “written statement” regarding the character of its distributions by posting the information on its website and advising its shareholders, in writing, to consult the website for this information.²⁸ This guidance is of particular importance given the recent implementation of SEC Rule 30e-3, which permits RICs to deliver shareholder reports by making them publicly accessible on a website, free of charge, and sending investors a paper notice of each report's availability by mail.²⁹ RICs typically include the character of distributions in the annual reports sent to shareholders. As many funds take advantage of the new SEC rule, RICs should be permitted to report distributions in publicly posted materials. Absent such guidance, RICs might be required to send a separate statement to shareholders for tax purposes. Such a requirement would be unnecessarily costly and burdensome.

Second, the Institute submitted a proposed Schedule D (Form 1120-RIC) to the IRS,³⁰ which would enable RICs to more accurately detail their capital gains and losses, rather than requiring a RIC to use the current generic form that applies to all corporations. As such, the proposed form would include information that is necessary to calculate a RIC's tax liability and would eliminate any information that is not. Specifically, the proposed Schedule D would eliminate the requirement for RICs to complete the Form 8949. The Institute also recommends that the IRS revise certain lines on the Form 1120-RIC to conform to changes implemented by the RIC Modernization Act.

B. Foreign Bank and Financial Account Reporting

The Institute urges that the proposed revisions³¹ to the Report of Foreign Bank and Financial Accounts (FBAR)³² filing requirements be modified to resolve ongoing difficulties for the fund industry. In light of the many issues raised with respect to FBAR, we encourage the government to conduct a comprehensive review of the FBAR reporting requirements to eliminate unnecessary filings that do not have the “high degree of usefulness in criminal, tax, regulatory, and counterterrorism matters” required by the Bank Secrecy Act.³³

The concerns expressed in the Institute's letter³⁴ relate to the likelihood that FinCEN will be overwhelmed by essentially worthless FBAR filings unless three different areas are addressed. Specifically, amendments are needed to prevent counterproductive FBAR filings by (1) persons employed by fund managers, (2) individuals with signature authority over 25 or more foreign accounts, and (3) both a fund and its US global custodian with respect to the same account. Our requested guidance is consistent with FBAR's purposes of thwarting abusive tax schemes and combatting terrorism; adopting our suggestions will lead to improved compliance.

C. Ownership Tracking Requirements

The Institute asks that a project be opened to amend the regulations under sections 382 and 383 with respect to ownership tracking requirements that apply to participant-directed retirement accounts holding RIC shares. Specifically, the regulations should permit a RIC to look through participant-directed retirement accounts and treat each participant/investor who holds less than five percent of the RIC's shares as part of the RIC's direct public group. The concerns addressed by sections 382 and 383 are not implicated when a RIC's new shareholders are retirement accounts that cannot benefit from such tax attributes.

This change effectively would prevent a large collection of small investors making independent investment decisions from being treated as a single entity for ownership change purposes. Absent this change, a retirement plan administrator's decision as to which RICs to offer in a plan could significantly affect whether other shareholders in the RIC can benefit from the RIC's capital losses even though the retirement plan administrator is neither a beneficial owner of RIC shares nor responsible for allocating investment assets among RICs. This scenario should not raise tax policy concerns.

D. Electronic Filing

The Institute recommends that a project be opened to implement electronic filing of Forms 1120-RIC. Specifically, we suggest that the Modernized e-File (MeF) system be updated to process Forms 1120-RIC. Electronic filing reduces tax compliance burdens on taxpayers, especially with respect to bulky corporate returns such at the 1120-RIC.

E. Cost Basis Reporting

The Institute continues to urge the IRS and Treasury Department to issue guidance clarifying several issues with respect to cost basis reporting. Specifically, we ask the IRS and Treasury Department to adopt in final regulations the rules provided in Notice 2011-56³⁵ regarding changes from a broker's default method of average cost, with the few modifications detailed in our previous letter.³⁶

We also urge the IRS and Treasury Department to reconsider the requirement that a shareholder who elects to use the average cost method, revokes such election, or changes from the average cost method (whether the broker default or a shareholder election) must do so in writing. Requiring such elections, revocations, and changes in writing is unnecessarily burdensome and potentially costly for shareholders.³⁷ The Institute instead proposes that the regulations permit brokers, including RICs, to provide a written confirmation to shareholders of a cost basis method election, revocation, or change, in lieu of a written notification by the shareholder.

The Institute also requests that several other issues regarding cost basis reporting be clarified. First, the IRS and Treasury Department should clarify that brokers may use any basis method as their default method for mutual fund shares, including first-in, first-out (FIFO), average cost, or any other formulaic method, as clearly intended by Congress. Second, we request that gifted shares have a carryover holding period, even if the shares were gifted at a loss (i.e., the cost basis of the gifted shares exceeds the fair market value on the date of gift) and the donee subsequently sells the shares at a loss. Third, we ask the IRS and Treasury Department to clarify that, for cost basis reporting purposes, shares acquired by an estate after the decedent's death have a basis equal to the fair market value on the date of acquisition, unless the broker receives other information from an estate representative. Finally, the IRS should (i) clarify whether RIC liquidating distributions are subject to cost basis reporting and; (ii) if so, amend Forms 1099-B and 1099-DIV, and the accompanying instructions, to specify that liquidating distributions by RICs should be reported on Form 1099-B, so that brokers can properly report cost basis information for such distributions.

III. Issues on Previous Years' Priority Guidance Lists

The Institute requests that the IRS and Treasury Department issue guidance on the following items that were on previous years' Priority Guidance Lists but were not included in the 2018-2019 Priority Guidance List.

A. Prepaid Forward Contracts

We urge guidance on prepaid forward contracts.³⁸ Specifically, the Institute strongly supports prompt and comprehensive guidance regarding the tax treatment of exchange-traded notes (ETNs). Although ETNs can provide important investment opportunities, they also take advantage of gaps in the tax law to provide investors with tax deferral (of up to 30 years) and character conversion that is inappropriate. This treatment is far more favorable than the treatment obtained by investors in comparable financial instruments and provides a tax incentive to take on issuer credit risk, rather than invest in products that do not entail this risk. In the absence of legislation, regulations should be issued under the Treasury Department's existing authority under section 1260 and should provide a mark-to-market election. If a comprehensive regulatory approach is not developed under section 1260, guidance should be issued under section 446 to address any ETNs that remain outside the scope of the section 1260 constructive ownership solution.

B. Notional Principal Contracts

The Institute remains very interested in guidance providing simplicity and certainty regarding the taxation of notional principal contracts. The Institute made a number of recommendations in our letters on the regulations proposed in 2004 and 2011.³⁹ We recommend that marks under the elective mark-to-market method, as well as value payments under the noncontingent swap method, be treated as resulting in capital gain or loss. We also suggest that credit default swaps and certain short-term swaps be excluded from the modified noncontingent swap method and the mark-to-market election. Further, we request additional guidance regarding the definition of “payment” and on several technical issues. Finally, we suggest that the guidance should be made entirely prospective upon promulgation of final regulations.

C. Distressed Debt

The Institute requests guidance addressing the accrual of interest on distressed debt. Investors have long faced uncertainty regarding how the existing original issue discount and market discount rules should apply to severely distressed, and speculative, debt. In other cases, application of these rules creates what many believe to be inappropriate results.⁴⁰ These issues have been exacerbated by the events of the financial crisis.⁴¹

IV. Other Issues Directly Affecting RICs and Their Shareholders

The Institute requests that the IRS and Treasury Department address issues arising from the application of the general corporate tax rules to RICs. These rules can be unnecessarily difficult to apply and can result in unintended consequences.

A. Business Continuity Requirement for Tax-Free Mergers

First, the Institute requests guidance clarifying the application of the “business continuity” requirement to RICs under section 368 and Treas. Reg. § 1.368-1(d)(2).⁴² This clarification is necessary because it is difficult to discern the intended scope of the business continuity test as applied to RIC reorganizations. As a result, many RICs engaging in merger transactions are compelled to rely on the “asset continuity” test;⁴³ this test, to the detriment of the RIC's shareholders, can place artificial limits on the ability of a portfolio manager to dispose of portfolio securities acquired from a target RIC and imposes significant compliance burdens on funds. The Institute requested guidance on this issue in 2004, at which point the IRS informed us that they wished to gather more information on RIC mergers through the private letter ruling process. The Institute hopes that the IRS and Treasury Department now have sufficient information to open a project on this issue and requests that they do so.

B. RIC Investments in Partnerships with Different Taxable Year-Ends

Second, we request guidance regarding RIC investments in a partnership in which the RICs and the partnership have different tax years; this guidance should allow RICs to take partnership items into income at the end of each month, rather than at year-end. In general, partners must take partnership items into account at the end of the partnership's tax year.⁴⁴ If a RIC invests in a partnership with a different tax year, however, this can cause mismatches between the RIC's distributions and the amount of earnings and profits associated with the partnership's income.