Firm Recommends Changes, Suggests Alternatives to RIC Regs

We are pleased to provide the following comments on Proposed Regulation 1.851-2 (the "Proposed Regulations").¹ Our comments are being provided on behalf of one of our clients, an investment management firm that is registered with the Securities and Exchange Commission as an investment adviser under the Investment Advisers Act of 1940.

The Proposed Regulations would be issued under section 851 of the Internal Revenue Code of 1986, as amended (the "Code"), and relate to, among other things, the gross income requirements that must be met in order for a corporation to qualify as a regulated investment company for U.S. federal income tax purposes (within the meaning of section 851 of the Code, a "RIC").

Among other things, the Proposed Regulations provide that,

On November 29, 2016, the Tax Section of the New York State Bar Association ("NYSBA") submitted its Report No. 1359 on the Proposed Regulations (the "NYSBA Report"), which included a thorough discussion of the relevant legislative and regulatory background of the RIC Income Test, as well as NYSBA's analysis of certain issues presented by the Proposed Regulations and its recommendations. This comment letter highlights certain positions set forth in the NYSBA Report and presents additional issues and concerns. In addition, this comment letter provides thoughts regarding the Effective Date.²

As noted in the NYSBA Report, prior to 1976, section 963 of the controlled foreign corporation ("CFC") provisions of the Code provided that a United States shareholder (as defined in Section 951(b) of the Code) would not recognize subpart F income from an investment in a CFC if the CFC distributed a specified minimum amount of its earnings and profits for the taxable year. Effective for taxable years beginning after December 31, 1975, section 963 was repealed, and the RIC provisions of the Code were amended to provide that

Such a rule was necessary as, for U.S. federal income tax purposes, except to the extent expressly provided in the Code, subpart F inclusions are not treated as "dividends," and income from subpart F inclusions did not otherwise qualify for the RIC Income Test at the time of the 1975 Act.⁴

In the Tax Reform Act of 1986⁵ (the "1986 Act"), Congress enacted the passive foreign investment company ("PFIC") provisions of the Code, which, like the CFC provisions of the Code, are an anti-deferral regime.⁶ The PFIC provisions of the Code included a "qualified electing fund" ("QEF") regime that allows a PFIC shareholder to elect to include in its taxable income, on a current basis, its share of a PFIC's ordinary income and net capital gains, in lieu of subjecting certain dividends and gains from the sale of the PFIC shares to ordinary income tax treatment and an interest charge on the shareholder's tax liability (on a "deemed deferred" basis).⁷

While such "QEF inclusions" generally are not treated as dividends for U.S. federal income tax purposes, under the 1986 Act, the RIC provisions of the Code were amended to treat QEF inclusions as dividend income for purposes of the RIC Income Test, but only to the extent such inclusions were accompanied by Current Distributions.⁸

Thus, following the 1986 Act, RICs were put on a similar footing as to whether subpart F inclusions and QEF inclusions were treated as dividends for purposes of the RIC Income Test. That is, in order to be treated as "dividends" for RIC Income Test purposes, such inclusions must be accompanied by Current Distributions. In addition, the 1986 Act provided that any amount included in a RIC's gross income pursuant to a RIC's mark-to-market election made with respect to a PFIC also would be treated as a "dividend" for purposes of the RIC Income Test.⁹

Importantly, the 1986 Act also provided that an additional category of income qualifying for the RIC Income Test includes

As noted in the NYSBA Report, the legislative history to the 1986 Act does not state whether CFC/QEF Inclusions are to be covered by the Other Income Exception, but the legislative history indicates that the Other Income Exception was supported by the Department of Treasury, and testimony from Department of Treasury Officials indicates that the Other Income Exception was intended to allow for the "liberalization of the types of income RICs may receive to include the passive investment income sources specified [in the provision]" provided that "RICs should not be permitted to engage in active business"¹² and, therefore, income qualifying for the RIC Income Test is limited to income from property held for investment, and derived from stocks and securities.¹³

Beginning in 2006, the Internal Revenue Service (the "IRS") issued a number of private letter rulings ("PLRs") holding that CFC/QEF Inclusions were qualifying income for purposes of the RIC Income Test under the Other Income Exception, The rulings relied on the Other Income Exception, in that they did not treat CFC/QEF Inclusions as "dividends," nor did they require Current Distributions in holding that CFC/PFIC Inclusions qualified for purposes of the RIC Income Test.¹⁴

As noted above, the Proposed Regulations provide that for purposes of the RIC Income Test and section (b)(l)(i)(A) of the Proposed Regulations, CFC/QEF Inclusions are treated as dividends for purposes of the RIC Income Test only to the extent that, under section 959(a)(1) or 1293(c) (as the case may be), there is a distribution out of the earnings and profits of the taxable year that are attributable to the amounts included in gross income for the taxable year under section 95 l(a)(l)(A)(i) or 1293(a) (i.e., only to the extent such CFC/QEF Inclusions are accompanied by Current Distributions).¹⁵ Such provision is consistent with the language of section 851(b) of the Code (indeed, the provision essentially restates the language in section 851(b)).

However, the Proposed Regulations further provide that, for purposes of the RIC Income Test and section (b)(l)(i)(F) of the Proposed Regulations, CFC/QEF Inclusions are not treated as income qualifying for the RIC Income Test under the Other Income Exception.¹⁶ In other words, under the Proposed Regulations, the exclusive manner in which CFC/QEF Inclusions qualify for purposes of the RIC Income Test is if such inclusions are accompanied by Current Distributions.

As support for such position, the preamble to the Proposed Regulations notes that the significance of treating CFC/QEF Inclusions as a "dividend" under Section 851 is that a dividend is qualifying income under section 851(b)(2) (i.e., the RIC Income Test), and that the amendments to section 851(b) made by the 1975 Act and the 1986 Act unambiguously require Current Distributions in order to treat CFC/QEF Inclusions as such qualifying income. The preamble further states that, absent a Current Distribution, there is no support in the Code for treating an inclusion under section 951(a)(l)(A)(i) or 1293(a) as a dividend under section 851.

Continuing, the preamble notes that, in certain circumstances, the IRS previously issued PLRs under section 851(b)(2) holding that CFC/QEF Inclusions qualify for purposes of the Other Income Exception, even in the absence of a Current Distribution. According to the preamble, reading section 851(b)(2) in this matter ignores the requirement in section 851(b) that that such amounts be accompanied by a Current Distribution in order to treat such inclusions as dividends, and the distribution requirement is a more specific provision than the other income clause (i.e., the Other Income Exception).

The preamble further states that it cannot be suggested that the Current Distribution requirement was superseded by the Other Income Exception because the Other Income Exception and the Current Distribution requirement for inclusions under section 1293(a) were both added by the 1986 Act.

For the reasons set forth below, we respectively disagree with the position set forth in the Proposed Regulations that CFC/PFIC Inclusions do not qualify for the RIC Income Test under the Qualifying Income Exception.

While the plain language of section 851(b)(2) requires a Current Distribution to qualify a CFC/QEF Inclusion as a dividend, the Other Income Exception has no Current Distribution requirement, and the Other Income Exception does not otherwise exclude CFC/QEF Inclusions.¹⁷ Thus, under the plain language of section 851(b)(2), while a CFC/QEF Inclusion may not qualify as a dividend for purposes of the RIC Income Test in the absence of a Current Distribution, such inclusions clearly represent income from a RICs business of investing in stocks and securities, and thus qualify for the RIC Income Test under the Other Income Exception.¹⁸

We further note that the Other Income Exception does not treat "other income" as dividends (or any other specific type of income), it simply states that such income qualifies for the RIC Income Test (provided that such income is derived with respect to the RICs business of investing in stocks and securities).¹⁹ No further requirements are necessary under Section 851(b)(2)(A) to treat such "other income" as qualifying for the RIC Income Test.

In this regard, Congress drew a further distinction between income treated as a "dividend" for purposes of the RIC Income Test in section 1296(h), which provides that any amount included in gross income by a RIC as a result of a PFIC mark-to-market election is treated as a "dividend" under section 851(b)(2). Congress could have provided that amounts included in gross income as a result of a mark-to-market election with respect to a PFIC are treated as "other income," but chose not to do so in favor of treating such amounts derived via a mark-to-market election as a "dividend" (which clearly they are not for general U.S. federal income tax purposes).

The IRS also recognized the distinction between CFC/QEF Inclusions treated as "dividends" for purposes of the RIC Income Test as opposed to income qualifying for the Other Income Exception in the PLRs, as such PLRs did not hold that such CFC/QEF Inclusions were treated as "dividends" for purposes of the RIC Income Test.²⁰ Rather, such PLRs held that the CFC/QEF Inclusions qualified for purposes of the RIC Income Test pursuant to the Other Income Exception.²¹ The fact that Current Distributions were not required in the PLRs is logical, as the Other Income Exception has no Current Distribution requirement.

While the reasons for the inclusion of both the Other Income Exception and the Current Distribution requirement are not clear (the NYSBA Report includes a discussion on this point), any lack of clarity should not be a basis to include an additional requirement in the Other Income Exception that does not exist in the Code.

We do not believe that the Current Distribution requirement with respect to CFC/QEF Inclusions is a more specific provision than the Other Income Exception, and thus should control. Rather, we believe that the Other Income Exception is clear, and that Treasury Regulations should not incorporate additional requirements that are (i) not contained in the Code and (ii) by their nature apply solely to classify income as "dividends" for purposes of the RIC Income Test.

In this regard, we note that while Congress has frequently modified the RIC provisions of the Code (including such fundamental changes such as (i) repealing the "short-short" test, (ii) including income from certain publicly traded partnerships as qualifying income for purposes of the RIC Income Test, (iii) certain specified changes pursuant to a RIC "Modernization Act," and (iv) making permanent the "interest related dividends" provisions of section 871(k)²²), the Other Income Exception remains unchanged for over 30 years. Further, Congress has been aware of the IRS' PLRs regarding the treatment of CFC/QEF Inclusions dating back to 2006, and has not acted to modify the U.S. federal income tax law in relation thereto.²³ If Congress believed that CFC/QEF Inclusions required a Current Distribution to qualify for the RIC Income Test (other than as a dividend), or that such inclusions should not otherwise qualify for purposes of the Other Income Exception, it has had ample opportunity to enact legislation to such effect.

Secondarily, the CFC and PFIC provisions of the Code are anti-deferral regimes. Preventing a RIC from making a QEF election with respect to a PFIC investment (e.g., if a RIC cannot obtain assurances from the PFIC that it will make Current Distributions) does not further the intended purpose of the PFIC provisions of the Code in preventing taxpayers from deferring the recognition of passive foreign income. Rather, if the Proposed Regulations are finalized in current form, RICs are less likely to make QEF elections with respect to their PFIC investments, as a QEF election has the potential to cause a RIC to fail to meet the RIC Income Test, while not making a QEF election should not cause a RIC to fail to meet the RIC Income Test (although the RIC would be subject to the PFIC "excess distribution" regime).²⁴

While many RICs may be able to make a mark-to-market election with respect to their PFIC investments, thus enabling such RICs to recognize income qualifying under the RIC Income Test from their PFIC investments²⁵, a RIC may not be able to make such election, either because the RIC does not meet the requirements to make such election²⁶, or because the RIC holds the PFIC through a domestic partnership that it does not control (including a domestic partnership that has already made a QEF election with respect to a PFIC).²⁷

In addition, all income from a mark-to-market election is treated as ordinary income for U.S. federal income tax purposes, thus depriving the RIC (and its shareholders) of the ability to recognize capital gain income from a PFIC investment for which a QEF election is made (either upon a sale of such PFIC investment, or on a pass-through basis from the PFIC's own capital gains).²⁸

For the foregoing reasons, the Proposed Regulations should not exclude CFC/QEF Inclusions from qualifying for the RIC Income Test under the Qualifying Income Exception.

Nevertheless, in the event that the Proposed Regulations are adopted in a form that excludes CFC/PFIC Inclusions from the Other Income Exception, we believe that the IRS should adopt a grandfathering rule that does not apply such requirements to a RIC's existing PFIC investments for which a QEF Election has been made (or will be made with respect to taxable years beginning before January 1, 2018), until a sufficient period of time has elapsed.

Given the express language of section 851(b)(2) and the PLRs granted by the IRS, many RICs have existing PFIC investments for which a QEF election has been made, but for which the RIC has not obtained assurances that such PFIC will make Current Distributions. In particular, such PFIC investments may be held through a RIC's investment in a private equity fund or a similar structure for which the RIC does not have the ability to obtain assurances that such PFICs will make Current Distributions. Also, depending upon the structure, a RIC may not have the ability to revoke a QEF election or to make a mark-to-market election with respect to a PFIC.²⁹ In such a case, the Proposed Regulations may effectively require a RIC to sell (potentially incurring an economic loss) its direct and indirect PFIC investments or jeopardize its qualification as a RIC.³⁰

Given the foregoing, and the typical investment term of a private equity fund, we would recommend that the Proposed Regulations not apply to a RIC's existing PFIC investments for which a QEF election has been made for taxable years beginning before January 1, 2018 for a period of seven (7) years following the Effective Date.

In addition, in the event that the Proposed Regulations are adopted in a form that excludes CFC/PFIC Inclusions from the Other Income Exception, we believe that the IRS should provide automatic consent for a RIC to revoke its existing QEF elections, on a PFIC-by-PFIC basis.³¹

We appreciate your consideration of our comments. If you have any questions or comments regarding this letter, please feel free to contact us and we will be glad to assist in any way.

Respectfully submitted,

² We are not in this letter providing comments on whether a financial instrument or position held by a RIC is a security under the Investment Company Act of 1940, including whether income from commodity-linked instruments is derived with respect to a RICs business of investing in debt securities for purposes of the RIC Income Test. The Notice requested comments on such issue, including whether Revenue Ruling 2006-1, Revenue Ruling 2006-31, and other previously issued guidance on such issue should be withdrawn as of the Effective Date.

³ Tax Reduction Act of 1975, Pub. L, 94-32 § 602(a)(1), 89 Stat. 26, 58 (the "1975 Act").

⁴See, Rodriguez v. Commissioner, 137 T.C. 174 (2011).

⁵ Pub. L. No. 99-514.

⁶ Code § 1297.

⁷ Code § 1293.

⁸ Code § 851(b).

⁹ Code § 1296(h).

¹⁰ Code § 851(b)(2)(A),

¹¹Id.

¹² NYSBA Report, 132 Cong, Rec. S8204 at 14992 (daily ed. June 24, 1986) (statement of Sen. Armstrong) ("The desire of the industry, which is supported, I think, without controversy or objection and enjoys the support of the Treasury Department, is to permit the mutual fund industry to make better use of income from stock options, futures contracts and options on stock industries, options and futures of foreign currencies, and foreign currency transactions").

¹³ NYSBA Report, citing Statement of Dennis E. Ross, Tax Legislative Counsel, U.S. Treasury Department, in "Hearings on Issues Relating to Passthrough Entities" before the Subcommittee on Select Revenue Measures of the Committee on Ways and Means at 137 (June 10, 1986).

¹⁴See, PLR 200946036 (Nov. 13, 2009); PLR 201122012 (June 3, 2011); PLR. 201206015 (Feb. 10, 2012).

¹⁵ Prop. Reg. § 1.85 l-2(b)(2)(i) (underline supplied).

¹⁶ Prop. Reg. § 1.851-2(b)(2)(iii).

¹⁷ Code § 851(b)(2)(A).

¹⁸ Absent, as noted in the NYSBA Report, a RICs holding of CFC or PFIC securities as a dealer (which would not be typical).

¹⁹ Code § 851(b)(2)(A).

²⁰ See, note 14 supra.

²¹Id.

²²See, Pub, L. 111-325 (Regulated Investment Company Modernization Act of 2010); Pub. L. 108-357 (American Jobs Creation Act of 2004); Pub. L. 105-34 (Taxpayer Relief Act of 1997); Pub. L. 100-647 (Technical and Miscellaneous Revenue Act of 1988); and Pub. L. 114-113 (Protecting Americans from Tax Hikes Act of 2015).

²³ Indeed, in enacting Section 856(c)(5)(J), which applies to real estate investment trusts ("REITs"), Congress specially authorized the IRS to expand the categories of income qualifying for purpose of the REIT income tests. In response to such section, the IRS has issued a number of private letter rulings treating certain CFC/QEF Inclusions as qualifying income under Section 856(c)(2) of the Code. See, PLR 201537020 (Sept. 11, 2015). Given that the REIT rules were modeled off of the RIC provisions of the Code, the IRS has often looked to the RIC rules for purposes of interpreting the REIT provisions of the Code when confronted with a lack of available authority under the REIT provisions of the Code, and vice versa. See, PLR 201122016 (June 3, 2011), citing Rev. Rul. 74-248, 1974-1 CB. 167. Thus, in our view, no inference should be given to the tack of legislative activity regarding the Other Income Exception as creating any need for the IRS to restrict the type of income qualifying for the Other Income Exception.

²⁴See, Code § 1291.

²⁵ Code § 1296(h).

²⁶ For example, if the RIC does not meet the requirements of Section 1296(e)(2), and if shares in the PFIC do not otherwise qualify as "marketable stock" within the meaning of section 1296(e)(1).

²⁷See, Treas. Reg. sections 1.1295-1(d)(l); 1.1296-l(b)(2).

²⁸See, Code sections 1296(c); 1293(a).

²⁹See, note 27 supra.

³⁰ While a RIC presumably would have reasonable cause for any failure to meet the RIC Income Test as a result of recognizing non-qualifying income from an existing PFIC, such failure to meet the RIC Income Test may result in penalties and interest. See, Code section 85 l(i).

³¹See, Code section 1296(b).