United States: Tax Talk: Volume 9, Issue 3

Editor's Note

Halloween is just around the corner, and if the government doesn't issue the section 385 regulations soon, the references to those controversial regs and "trick or treat" in law firm client alerts will be overwhelming (and not that funny). Tax Talk is making no predictions on the regulations, but we do give the reader an update on various related developments in Tax Talk 9.03. We also cover the latest development in commodity‑oriented regulated investment companies ("RICs"). For over a decade, the small investor has sought a way to invest in commodities through open or closed end mutual funds. Unfortunately, commodities were not much of an investment class in 1942 when the predecessor of subchapter M was enacted by Congress, and RICs, therefore, were basically restricted to investments in securities. In the early 2000s, investment advisors bridged the gap using commodity swaps. They would get opinions from their erstwhile '40 Act legal advisers that such swaps "should" be securities under the '40 Act and, therefore, were securities under the RIC rules. The Internal Revenue Service ("IRS") put a stop to that in Rev. Rul. 2006‑1. However, the pressure from investors was great enough that the government agreed to a two part workaround: (i) the IRS would rule privately that certain structured notes were securities under subchapter M, and (ii) the IRS would provide private letter rulings that made investing in commodities through a foreign corporation relatively easy. Many rulings were issued until 2011 when the government stopped ruling, perhaps because Congress was casting its gaze on Cayman Islands corporations used by U.S. taxpayers for all sorts of purposes and saw lots of commodity investing Cayman subsidiaries formed by U.S. RICs. Anyway, Tax Talk 9.03 describes the latest round in this saga which involves the government trimming back its 10 year old private letter ruling policy.

Tax Talk 9.03 also covers temporary regulations on electing into the new partnership audit rules, updated highlights of the presidential candidates' tax plans, the final regulations defining marital status, and more.

IRS Issues Proposed Regs on RIC Commodity Investments

On September 27, 2016, the IRS issued proposed regulations (the "Proposed Regulations") providing guidance relating to the income test and asset diversification requirements for determining whether a corporation qualifies as a RIC for federal income tax purposes. Generally, the Proposed Regulations state that (a) the IRS will no longer rule on what assets are securities for the purposes of section 851 and this determination will be made under the Investment Company Act of 1940, as amended (the "1940 Act"),¹ and (b) inclusions from controlled foreign corporations ("CFCs") and passive foreign investment companies ("PFICs") will not be treated as dividends for purposes of the income test without a corresponding distribution from a foreign subsidiary's earnings and profits. This guidance is the first word on these issues since the IRS suspended its issuance of private letter rulings ("PLRs") relating to commodity linked notes and indirect investments in commodities through wholly‑owned subsidiaries in July 2011.

"Security" for RIC Rules

Generally, in order for a corporation to qualify as a RIC for a taxable year, it must meet the income test of section 851(b)(2) and the asset diversification requirements of section 851(b)(3). In the past, the IRS has addressed whether certain instruments or positions are "securities" for purposes of section 851. Principally, the Preamble to the Proposed Regulations discusses Revenue Ruling 2006‑1, in which the IRS concluded that a derivative contract with respect to a commodity index is not a security for purposes of section 851(b)(2). Revenue Ruling 2006‑1 was then modified by Revenue Ruling 2006‑31, which stated that Revenue Ruling 2006‑1 was not meant to preclude certain instruments (e.g. structured notes) creating commodity exposure from being "securities" for the purposes of the RIC rules. After Revenue Ruling 2006‑31 was issued, the IRS received and granted numerous ruling requests concerning whether certain structured notes were "securities" for purposes of the RIC rules.²

Under the Proposed Regulations, the IRS will no longer rule on what constitutes a "security" for the purposes of the RIC rules. Instead, the determination of what is a "security" for the purposes of the RIC rules will be made under section 2(a)(36) of the 1940 Act. At the same time the IRS released the Proposed Regulations, it also released Rev. Proc. 2016‑50, which provides that the IRS will not ordinarily issue rulings or determination letters on issues relating to the treatment of a corporation as a RIC that require a determination of whether a financial instrument is a "security" under the 1940 Act. The IRS has requested comments as to whether Revenue Ruling 2006‑1, Revenue Ruling 2006‑31, and other previously issued guidance that involves determining what assets are "securities" under the 1940 Act should be withdrawn effective as of the date the Proposed Regulations are finalized.

Inclusions from CFCs and PFICs

Apart from using structured notes to gain exposure to commodities, RICs also use investments in wholly‑owned foreign subsidiaries to gain such exposure. Those foreign subsidiaries invest in commodity futures and other commodity derivatives. When such subsidiaries are wholly‑owned by U.S. corporations, those entities become CFCs and are therefore subject to subpart F of the Code. Generally, a CFC is a foreign corporation where U.S. persons separately owning at least 10% of the voting power together own 50% of the voting power of such corporation, and a PFIC is a foreign corporation with 75% of its gross income being passive income or 50% or more of its assets being held for the production of passive income.³ U.S. shareholders of a CFC are taxed on a current basis on passive income received by the CFC from dividends, interest, rents, and royalties, regardless of whether or not such income is distributed to such shareholders. Beginning in 2006, the IRS issued a significant number of PLRs holding that inclusions of subpart F income by a RIC would qualify for the purposes of the RIC income test,⁴ regardless of whether the wholly‑owned subsidiary giving rise to the subpart F income made a distribution out of its earnings and profits to its RIC parent. The rulings concluded that CFF inclusions were "other income derived with respect to" a RIC's business of investing in securities under section 851(b)(2). The Proposed Regulations state that inclusions from a CFC or PFIC held by a RIC will be treated as qualifying for the RIC asset test only to the extent that there is a corresponding distribution of cash or other property out of its earnings and profits.

The Proposed Regulations for inclusions from CFCs and PFICs apply to tax years that begin on or after the date that is 90 days after the date the final version of the Proposed Regulations is published in the Federal Register.

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Footnotes

1 All section references are to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder, unless otherwise indicated.

2 See, e.g., PLR 200628001, PLR 200637018, and PLR 200647017, among a number of others.

3 If the CFC rules apply to a foreign subsidiary, the PFIC rules do not apply. Therefore, a foreign subsidiary wholly-owned by a U.S. RIC is a CFC and not a PFIC.

4 See PLR 200647017, PLR 200741004, PLR 200743005, and PLR 200822010, among others.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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