Regulated investment companies planning to terminate their operations and make final distributions could run afoul of tax rules without specific guidance on fund liquidations.
Navigating fund liquidations has become “top of mind for a lot of fund sponsors” dealing with the effects of the coronavirus pandemic on the financial markets and their portfolios, Scott Borchardt of PwC said September 22 during the Investment Company Institute’s virtual tax and accounting conference.
Morgan, Lewis & Bockius LLP said in an alert earlier this year that “during the current COVID-19 pandemic, both RICs and [real estate investment trusts] are likely to experience . . . tax-related challenges that may put pressure on their ability to satisfy applicable requirements under Subchapter M of the Code.”
For example, open-end RICs, which offer to redeem their shares on demand, “may experience significant redemptions causing the RICs to have to liquidate,” which create complications vis-a-vis the tax rules, according to the alert.
To qualify for special tax treatment — distributed earnings are taxed at the investor level and not at the entity level via a dividends paid deduction — RICs must, among other things, meet specific election, gross income, and asset diversification requirements. RICS must also distribute at least 90 percent of their taxable income annually.
“Oftentimes, [those] important and relevant rules don’t contemplate the liquidation of a RIC, creating uncertainty and traps for the unwary practitioners,” Borchardt said.
Borchardt noted that the institute is spearheading the development of a proposal that will be submitted to the IRS to address several challenges that could jeopardize a RIC’s treatment in the quarter and year of liquidation: the application of the personal holding company rules; the asset diversification test; the conduit treatment requirement; and tax reporting of final distributions.
“The key theme to these proposed changes is a recognition that the adoption of a plan of liquidation is a meaningful event,” Borchardt said, adding that plan adoption marks the entity’s transition from a company “seeking to meet an investment objective laid out in regulatory documents to an entity whose sole purpose is to wind down its affairs, liquidate its assets, and return capital to shareholders.”
Thus, the RIC requirements — which implicitly assume the entity is operating under normal circumstances — shouldn’t be applied after the plan is adopted, according to Borchardt.
One question still being hammered out in the draft proposal is “when has a fund adopted a plan of liquidation — is it when the board approves it or [at] some other time?” Karen Lau Gibian of the Investment Company Institute said, noting that fund liquidation issues have “been out there for a very long time.”
Avoiding Personal Holding Company Status
Under section 542, a corporation — subject to some exceptions — is deemed a personal holding company if more than 60 percent of its adjusted ordinary gross income is passive-type income, and “at any time during the last half of the tax year more than 50 percent of the value of outstanding stock is owned, directly or indirectly, by or for not more than 5 individuals.”
Corporations falling within that definition are subject to a 20 percent tax on their undistributed income.
As RICs move toward their final liquidation date, their shareholder composition can change significantly and unexpectedly, potentially causing the RIC to trigger personal holding company status, Borchardt said. That can disrupt “carefully laid-out plans on how the liquidation is going to be executed from a tax perspective,” he added.
If a RIC becomes a personal holding company, it will be precluded under section 562 from treating liquidating distributions as dividends for purposes of computing the dividends paid deduction and avoiding corporate-level tax.
If that occurs, a RIC could face challenges satisfying the statutory distribution requirements in the fund’s final year, according to Borchardt.
The proposal being drafted for submission to the IRS would provide RICs relief by making the personal holding company testing date “the date the plan of liquidation is adopted . . . so long as the liquidation occurs within 90 days of adoption,” Borchardt said.
Diversification Dilemmas
Similarly, relief is needed regarding the asset diversification requirements — that is, that the date for measuring compliance for the RIC’s final quarter be when the plan of liquidation is adopted rather than the liquidation date, if the liquidation occurs within 90 days, Borchardt said.
Under section 851(b), at the end of each quarter at least 50 percent of a fund’s total asset value must be represented by cash, cash items, government securities, securities of other RICs, or securities of any one issuer that doesn’t represent more than 5 percent of the taxpayer’s assets and more than 10 percent of the outstanding voting securities of the issuer.
Also, generally no more than 25 percent of a RIC’s assets can be invested in the securities of any one issuer, in the securities of two or more issuers controlled by the RIC and in a similar trade or business as the RIC, or in the securities of one or more qualified publicly traded partnerships.
A RIC could run afoul of the diversification requirements because it might be unable to fully liquidate its portfolio at one time if some liquid securities are difficult to sell or otherwise dispose of, resulting in those transactions occurring after the end of a quarter, Borchardt said.
That could lead to portfolio decisions “being made [only] to comply with the tax rules” that aren’t in the best interest of fund shareholders, Borchardt said.
Another challenge for RICs that have to liquidate is satisfying the asset requirements under sections 852 and 853, according to the Morgan, Lewis & Bockius alert.
Under those provisions, if a RIC intends to “pass through the special character of certain tax items to shareholders (i.e., exempt interest income and foreign tax credits), [it] must meet one of certain thresholds relating to the nature of its assets at the close of each quarter or taxable year,” the alert said.
That requirement for conduit treatment “is one that tends to cause a fair amount of hammering among practitioners because the outcome is rather draconian if you have an exempt fund and you can’t pay [exempt] interest dividends due to the technical application of the rules,” Borchardt said.