Mutual funds affected by the coronavirus pandemic could fall prey to rules that limit the use of losses following an ownership change of a loss corporation, potentially yielding peculiar results.
Domestic corporations that satisfy specific requirements and elect to be treated under subchapter M of the tax code as regulated investment companies — which includes mutual funds — can achieve single-level taxation via a dividends paid deduction. RICs, however, encounter a great many issues because they are subject, with some exceptions, to the general C corporation tax provisions, including the section 382 loss limitation rules.
The extreme market volatility in 2020 highlights “a quirk” in the section 382 rules that can yield “unexpected results and potentially be a trap for the unwary,” Scott Borchardt of PwC said January 27 during an American Bar Association Section of Taxation virtual meeting.
There’s a correlation “between market dips and mergers of RICs or a reallocation of capital by significant shareholders” that results in section 382 ownership changes, and therefore potentially triggers limitations in the future use of realized and unrealized losses, Borchardt said.
Congress enacted section 382 to prevent loss trafficking by limiting a loss corporation’s ability to use net operating losses and other tax attributes that arose before an ownership change.
The statute limits some pre-ownership-change losses that can offset future taxable income for five years after an ownership change.
A loss corporation subject to section 382 limitations includes a corporation with an NOL carryover or an NOL for a tax year in which an ownership change occurs, or with a net unrealized built-in loss (NUBIL), unless otherwise provided in regulations. Loss corporations also include those with a disallowed business interest carryforward under section 163(j) or pre-ownership-change capital loss or capital loss carryover described in reg. section 1.383-1(c)(2)(i) and (ii).
Common Facts; Odd Results
Complexities abound in applying section 382 to RICs, with potentially significant and unexpected implications arising in different fact patterns, particularly regarding the definition of an ownership change, according to Borchardt.
Under section 382(g), an ownership change occurs if, immediately after any owner shift involving a 5 percent shareholder or any equity structure shift, the percentage of the stock of the loss corporation owned by one or more 5 percent shareholders has increased by more than 50 percentage points over the lowest percentage of stock of the loss corporation owned by those shareholders at any time during the testing period.
Parsing that definition, Borchardt said the relevant concepts that illustrate the issues for RICs are owner shift, loss corporation, and testing period.
Borchardt put forward an example representing a common fact pattern in which a calendar-year RIC doesn’t have a capital loss carryover from 2019 or a capital loss for the tax year that ended December 31, 2020. For approximately 87 days between March 6, 2020, and May 31, 2020, based on the mathematical computations under section 382(h), the RIC had a NUBIL.
Borchardt pointed out that under those facts and reg. section 1.382-2T(d)(3), the beginning of the testing period is January 1, 2020. On that date, shareholder A owns 80 percent of the fund and shareholder B owns 20 percent. The RIC isn’t a loss corporation and there’s no owner shift, and therefore there’s no ownership change, Borchardt said.
On January 27, 2020, shareholder A is no longer an investor and shareholders C and D become new investors, with each owning 40 percent of the RIC. Borchardt said that means January 27 is a testing date for which there is an owner shift that results in more than a 50 percent change with the combined activities of shareholders C and D.
The fund, however, doesn’t have a NUBIL, so it’s not a loss corporation and there’s no ownership change for purposes of the section 382 loss limitation rules, Borchardt explained.
With open-end RICs, small changes in relative ownership could occur between January 28, 2020, and March 5, 2020, with each change resulting in a testing date that yields an owner shift with a greater-than-50-percent change, Borchardt said. “But once again, that owner shift and 50 percent change is disregarded under the rules until you get to March 6.”
The fact pattern — minor changes in owner shift before March 6, 2020, with that date being the first time the RIC has a NUBIL — results in the fund being a loss corporation with an ownership change, potentially subject to limitations on that loss, Borchardt said.
The anomaly is that the beginning of the section 382 testing period under the facts is fixed as the first day of the year, and so mathematically changes in ownership after January 1, 2020, contributed to a deemed change in ownership on March 6, Borchardt explained. “It’s kind of counterintuitive because . . . the significant change in ownership happened at a time when there were no losses,” he said.
Borchardt said that with more downward pressure on the market and more investors redeeming out of funds, a significant portion of the NUBIL could be recognized within a short time period, leading to an unexpected significant limit on losses.
Seed Capital Predicament
In a December 2019 article published in Tax Notes, Stephen D. Fisher, formerly of EY, explained how “a fund sponsor’s contribution of start-up (or seed) capital to a RIC . . . [increases] the likelihood that the loss limitation rules will apply to a RIC.”
“The potential inequity of this situation — subjecting a RIC to the loss limitation rules, to which it would not be subject absent the sponsor’s contribution — is exacerbated by the fact that the shareholder activity that causes the loss limitation rules to apply to a RIC may occur when the RIC has no losses,” Fisher wrote.
Fisher’s scenarios involve a C corporation sponsor contributing seed money to a RIC on the date the fund is organized, which is January 1, 2020, in exchange for 100 percent of the fund’s shares, which is followed by investments by the public. Fisher’s examples and analysis implicate other rules under section 382, such as those related to “stock issuances and redemptions that can create additional public groups,” which he noted the regs refer to as segregation.
In discussing one scenario, Fisher said the results appear “anomalous because only a small portion of the RIC’s stock . . . was transferred when the RIC was a loss corporation.” In those cases, there “does not appear to be any material trafficking in losses that one would expect to be present to trigger the application of section 382,” he wrote. “The bulk of the stock transfer . . . occurred when the RIC had no NOL carryforwards, [capital loss carryforwards], current-year operating losses or net realized capital losses, or NUBIL.”
According to Fisher, under the facts he presented, the regulations could prevent an ownership change from occurring, and therefore avoid triggering potential loss limitations, if “in determining each 5 percent shareholder’s lowest ownership percentage, one does not look back to a date before the corporation became a loss corporation.”
Fisher argued that the preamble to the 1987 regulations (T.D. 8149) suggests that result, because it states that “a testing period does not begin until a corporation is a loss corporation [and] . . . shifts in ownership that occur before the date that a corporation becomes a loss corporation thus are disregarded.” Fisher further noted that the result appears consistent with the legislative history of section 382, but the temporary regulations provide for a different outcome.
The odd results arising in situations in which “a RIC may be subject to the loss limitation rules solely because of its sponsor’s contribution of seed capital” — which doesn’t implicate the concerns underlying section 382 — could be “largely eliminated,” according to Fisher. He suggested that the testing dates and testing period for an ownership change be teed off a date that is “no earlier than a specified number of days after a sponsor’s initial contribution of seed capital.”
According to Fisher, a 90-day period after the sponsor’s contribution seems appropriate for not applying the loss limitation rules to RICs, similar to the IRS’s conclusion in Rev. Rul. 73-463, 1973-2 C.B. 34, in determining deductibility of stock issuance expenses following an open-end RIC’s initial stock offering.
Long-Standing Issues
The section 382 issues for mutual funds highlight “how some of the C corporation rules don’t always work well for RICs” and don’t operate in a way that reflects the underlying policy, said Amy Snyder of EY, who joined Borchardt on the ABA panel.
“When you’re dealing with open-end mutual funds, you can get these odd results,” Snyder said.
The Investment Company Institute (ICI) has long since identified issues arising from the application of general corporate tax rules to RICs, which it said “can be unnecessarily difficult to apply and can result in unintended consequences,” according to several letters to Treasury and the IRS.
For example, the ICI has repeatedly urged the government to modify regulations under sections 382 and 383 regarding ownership tracking requirements that apply to participant-directed retirement accounts holding RIC shares.
In a June 2019 letter, the ICI renewed its request that RICs be permitted “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 institute argued that the concerns addressed by the loss limitation rule “are not implicated when a RIC’s new shareholders are retirement accounts that cannot benefit from such tax attributes.”
The ICI said its recommendation “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.”
Another problematic corporate rule for RICs, according to the ICI, is the business continuity requirement under section 368 for tax-free mergers — an issue it raised in 2004 and in subsequent letters requesting projects for inclusion in Treasury and the IRS’s annual priority guidance plans.
The ICI explained in the 2019 letter that “it is difficult to discern the intended scope of the business continuity test as applied to RIC reorganizations” without guidance. “As a result, many RICs engaging in merger transactions are compelled to rely on the ‘asset continuity’ test, [which] . . . 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 IRS had informed the ICI that it “wished to gather more information on RIC mergers through the private letter ruling process,” the letter said, noting that the ICI hoped that had occurred and urging Treasury and the IRS to initiate a project to address the issue.