January 6, 2011

TO: Distribution

FROM: Burt, Staples & Maner, LLP

RE: 2010 Changes to RIC Distribution Rules

Year-end legislative changes to the Regulated Investment Company (“RIC”) distribution rules provide significant benefits for both payors and RIC investors. The most significant changes are contained in sections 301, 303, and 306 of the Regulated Investment Company Modernization Act of 2010 (H.R. 4337), enacted December 27, 2010, and sections 748 and 749 of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (H.R. 4853), enacted December 17, 2010.

Reinstatement of the Interest-Related and Short-Term Capital Gain Dividend Exceptions for Non-U.S. Investors in RICs.

• Prior law: Prior to 2010, interest-related dividends (generally, dividends attributable to interest that would qualify for the short-term obligation, portfolio interest, or bank deposit interest exceptions from withholding) and short-term capital gain dividends were exempt from withholding if paid to a non-U.S. person. The exceptions expired for RIC taxable years beginning after December 31, 2009, however.
• Legislative change: The interest-related and short-term capital gain dividend exceptions have been extended, with retroactive effect, to RIC taxable years beginning after December 31, 2009, through RIC taxable years beginning on or before December 31, 2011.
  • Withholding agents may, but are not required, to refund amounts withheld from distributions made in calendar year 2010 that qualify for the exceptions under the “reimbursement” or “set-off” procedures described in Treas. Reg. § 1.1461-2.

Elimination of 60-Day Designation Requirement.

• Prior law: A RIC paying a distribution of (i) a capital gain dividend (generally, a dividend attributable to net long-term capital gains less net short-term capital losses); (ii) an exempt-interest dividend (generally, a dividend attributable to interest on tax-exempt bonds), (iii) an interest-related dividend; (iv) a short-term capital gain dividend, (v) a dividend carrying foreign tax credits, or (vi) a dividend carrying credits from tax credit bonds was required to “designate” the distribution as one of the foregoing types of dividends in a written notice mailed to its shareholders not later than 60 days after the close of the RIC’s taxable year.
• Legislative change: The “designation” provisions have been eliminated and replaced by a requirement that the dividends be “reported” by the RIC in written statements furnished to its shareholders. The Technical Explanation to the Regulated Investment Company Modernization Act (September 28, 2010) states that the written statement requirement can be met by providing the investor with a Form 1099 containing information on the character of a distribution. Although not addressed in the Technical Explanation, the Form 1042-S should also meet the written statement requirement when a withholding agent is required to report the dividend to a non-U.S. person. The new reporting rules apply to RIC taxable years beginning after December 27, 2010.
  • Note that the legislation does not change the requirement that a RIC provide its U.S. shareholders a designation regarding undistributed capital gains within 60 days of the close of the RIC’s taxable year.

Modification of Dividend Allocation Rules.

• Prior law: The amount of a capital gain dividend, exempt-interest dividend, interest-related dividend or short-term capital gain dividend is determined at the end of a RIC’s taxable year. The amounts reported on Forms 1099 and 1042-S are determined on a calendar year basis. Thus, if a RIC has a taxable year other than the calendar year, it must determine the amount of a distribution that qualifies as a dividend of one of the foregoing types before the end of its taxable year. Under prior law, if the amount of a distribution that was designated as being a dividend of a specific type exceeded the actual amount of the distribution that could be treated as a dividend of that type, the RIC had to adjust all the distributions made during its taxable year and amend its Forms 1099 and 1042-S for distributions that were paid during its taxable year and on or before December 31.
• Legislative change: The new legislation provides a special rule that allocates the excess of the reported amount of a specific type of dividend over the actual amount of the dividend to post-December 31 distributions if the post-December 31 reported dividends are equal to or greater than the excess. For example, assume a RIC with a taxable year ending June 30, 2010, makes distributions of $30,000 at the end of September 2011, December 2011, March 2012 and June 2012. The reported capital gain dividends equal $120,000. If the RIC has only $100,000 of actual net capital gains for its taxable year, the reported amount of capital gain dividends exceeds the actual amount by $20,000. Because the post-December 31 reported capital gain dividends of $60,000 are greater than the $20,000 excess, the entire $20,000 excess amount is allocated to the two post-December 31 distributions. Thus, one-half of the excess, or $10,000, is allocated to each of the March 2012 and June 2012 distributions (i.e., $30,000/$60,000 x $20,000) to reduce the amount of each of those distributions treated as a capital gain dividend from $30,000 to $20,000. If, however, the RIC had only $40,000 in net capital gain for its taxable year, then the reported amount would exceed the actual amount by $80,000. Because the post-December 31 reported capital gain dividends of $60,000 are less than the excess reported amount of $80,000, the excess reported amount is allocated among all the reported capital gain dividends paid in the RIC’s taxable year in proportion to the amount that each reported capital gain dividend bears to the total reported capital gain dividends. Therefore, $20,000 ($30,000/$120,000 x $80,000) is allocated to each distribution, reducing the amount of each distribution treated as a capital gain dividend from $30,000 to $10,000.

Changes Related to Funds of Funds.

• Prior law: A RIC that was a fund of funds could not pass through exempt-interest dividends or foreign tax credits on dividends from lower-tier RICs because, by holding only stock in other RICs, it could not meet the requirements that at least 50% of its assets consist of tax-exempt obligations or that more than 50% of its assets consist of stock or securities in foreign corporations, respectively.
• Legislative change: If a RIC is a “qualified fund of funds” it can pay exempt-interest dividends and elect to allow its shareholders foreign tax credits without regard to the 50% requirements. A RIC is a “qualified fund of funds” if 50% or more of the total value of its assets consists of interests in other RICs, as determined on a quarterly basis.
  

Distributions in redemption of stock.

• Prior law: A payment made in redemption of stock in a RIC was treated as an exchange if one of four tests were met. If none of the tests were met, the payment was treated as a dividend. The most significant test for open-end RICs was that the distribution made in a redemption not be “essentially equivalent to a dividend.” Under case law and IRS revenue rulings, a beneficial owner’s proportionate ownership of a RIC had to decline for the distribution to be treated as an exchange and not a dividend. The determination of whether there was a reduction in a shareholder’s proportionate ownership in a RIC was difficult, if not impossible, in the case of open-end funds, which issue and redeem shares continuously.
  
• Legislative change: The legislation adds a fifth test for exchange treatment when stock of a RIC is redeemed. A redemption of stock of a publicly offered RIC is treated as an exchange (and not a dividend) if the redemption is made upon the demand of the shareholder, the RIC issues only stock which is redeemable upon the demand of the stockholder, and future regulations do not provide otherwise. If the new test is met, a payment to a U.S. non-exempt recipient is reportable on Form 1099-B. A non-U.S. beneficial owner that meets the test is not subject to tax, withholding or Form 1042-S reporting. The new rule applies to payments made after December 27, 2010.
  

RIC Qualified Investment Entity Treatment under FIRPTA.

• Prior law: A non-U.S. person is subject to tax and withholding under FIRPTA (sections 897 and 1445 of the Code) if the non-U.S. person has gain from a disposition of a U.S. real property interest (a “USRPI”). A non-U.S. person is treated as having gain from the disposition of a USRPI if it receives a distribution from a RIC that is attributable to the RIC’s sale or exchange of a USRPI. Under prior law, a non-U.S. person was not subject to tax or withholding under FIRPTA if the distribution was made with respect to stock that was regularly traded on a U.S. established securities market so long as the non-U.S. person did not own more than 5% of the class of stock at any time during a one-year period ending on the date of distribution. The exception sunsetted on December 31, 2009.
• Legislative change: The new legislation applies the 5%-or-less exception from FIRPTA tax from January 1, 2010 through December 31, 2011. There is no relief, however, from FIRPTA withholding for any payment made before December 17, 2010.