A Closer Look at RIC Diversification Testing

Posted by Investment Management Group on Feb 15, 2012 7:18:20 PM

In a previous post, we took a look at the technical requirements of the asset diversification tests that a fund must pass in order to qualify as a regulated investment company (“RIC”) for federal income tax purposes. In this post, we will dive deeper into these rules by looking at a case study of a “close call” for a fund that on the surface would appear to have failed the test. We will examine in depth one of the important exceptions to a mutual fund diversification test failure.

As mentioned above, this post will take the form of a case study. We will unoriginally call our fund the Case Fund, and we will assume that the Case Fund uses a September fiscal year-end.

As of 9/30/11, the Fund has $3,000,000 in total assets. Furthermore, the Fund holds the following securities that represent more than 5% of total assets:

Stock A

390,000

13.00%

Stock B

176,000

5.87%

Stock C

389,000

12.97%

Stock D

375,000

12.50%

Stock E

154,000

5.13%

Notes F,G & H (3 securities, 1 issuer)

154,000

5.13%

     
 

1,638,000

54.60%

On the surface, it would appear that the Fund fails the RIC diversification test, which would require that the percentage of gross assets that the above securities represent be at or below 50%. However, Internal Revenue Code (“IRC”) section 851(d)(1) affords the Fund the opportunity to pass the diversification test, if certain conditions are satisfied. The relevant part of the code section reads as follows (emphasis added):

A corporation which meets the requirements of subsections (b)(3) and (c) [i.e. the asset diversification tests] at the close of any quarter shall not lose its status as a regulated investment company because of a discrepancy during a subsequent quarter between the value of its various investments and such requirements unless such discrepancy exists immediately after the acquisition of any security or other property and is wholly or partly the result of such acquisition.

An analysis of this exception, as it relates to the Fund’s situation, can be made as follows:

  • If the Fund passed in the immediately preceding quarter (which for purposes of this case we will assume it did), it will not fail the test in the current quarter, unless both of the following two conditions apply:
    • The Fund would fail the test immediately after the purchase of the offending security or securities, and
    • The failure resulted in whole or in part from the acquisition of the offending security or securities

In order to properly make this analysis, the following three security purchases and corresponding dates have to be looked at closely. These security purchases are as follows:

400 shares of Stock E on 9/2/2011

2,200 units of Note F on 9/2/2011

2,500 units of Note G 9/21/2011

Accordingly, under the above decision tree, two days, 9/2/2011 and 9/21/2011, first have to be tested to see if the Fund failed immediately after the above acquisitions. These tests (utilizing the gross assets per the Fund’s closing trial balance for that day – T+1 basis) are as follows:

9/2/2011      
Gross assets

3,226,000

   
5%

161,300

   
       
       
Stock A

329,000

10.20%

 
Stock B

245,000

7.59%

 
Stock C

455,000

14.10%

 
Stock D

276,000

8.56%

 
Stock E

146,000

 

4.53%

Notes F,G & H (3 securities, 1 issuer)

149,000

 

4.62%

       
 

1,600,000

40.45%

 

As demonstrated, the Fund would not fail the test immediately after the acquisition of the offending securities on 9/2/2011, therefore the relief described above applies.

With respect to 9/21/2011:

9/21/2011

     
Gross assets

3,150,000

   

5%

157,500

   
       
       
Stock A

295,000

9.37%

 
Stock B

235,000

7.46%

 
Stock C

427,000

13.56%

 
Stock D

425,000

13.49%

 
Stock E

140,000

 

4.44%

Notes F,G & H (3 securities, 1 issuer)

195,000

6.19%

 
       
 

1,717,000

50.06%

 

Accordingly, immediately after the acquisition of the securities in question on 9/21/2011, the Fund would not pass the test, and therefore does not meet both conditions in IRC 851(d)(1) and relief would not apply.

As subtly noted at the onset of these examples, the computation made immediately above utilizes the gross assets as shown on the trial balance for the Fund on the day the acquisition was made and therefore does not include the acquired securities (2,500 units of Note G) themselves nor any other securities acquired on that day (including the appreciation or depreciation thereon) - due to the use of T+1 accounting – i.e. the common practice utilized in mutual fund accounting of recording security purchases and sales on the day after trade date. Such gross assets would, however, include the cash eventually used to settle the purchase of the 2,500 units of Note G. What if the purchase of the 2,500 units of Note G was included as of trade date instead of the T+1 date in testing for diversification? The gross assets would be greater and the result could potentially be different. The gross assets would be greater due to the fact that by using trade date accounting instead of T+1 accounting, the purchased security and the cash that will eventually be used to settle the trade will both be included in gross assets. This is due to the presence of a “payable for securities purchased” on the trade date balance sheet that would not exist on the T+1 balance sheet – effectively grossing up the Fund’s assets through the use of “borrowed” money. To some, this may seem an aggressive interpretation – effectively double counting the same assets in the denominator of the diversification test calculation. Others may see this to be a perfectly logical conclusion, given that generally accepted accounting principles (“GAAP”) requires trade date accounting. This makes a study of the definition of the term “total assets” in order.

The tax code does not define “total assets” for this purpose. That said, the regulations interpreting a similar diversification test for Real Estate Investment Trusts (REITs), defines “total assets” to be “the gross assets of the trust determined in accordance with generally accepted accounting principles.” REIT regulations are often referred to for guidance when RIC rules interpreting RIC code sections do not exist, due to the similarity between the RIC and REIT tax regimes. Further, IRC section 851(c)(6) provides that other terms, i.e., those not defined in IRC section 851, have the same meaning as when used in the 1940 Act. The term “total assets” is not defined in the 1940 Act statutes, however it is defined in Rule 5b-1 under the 1940 Act. That rule says, “the term total assets, when used in computing values for the purposes of sections 5 and 12 of the Act, shall mean the gross assets of the company with respect to which the computation is made….” 1940 Act registered funds are required to prepare their financial statements using GAAP. It is therefore reasonable to assume that total assets, as determined under GAAP, should be used as the total assets for purposes of the diversification test for two reasons, 1) because the analogous REIT rules specifically reference GAAP in their definition of total assets and 2) the RIC rules specifically state that where a term is not defined in the RIC tax statutes, it shall have the same definition as is used for 1940 Act purposes, which given the manner in which 1940 Act Funds are required to prepare their financial statements, infers total assets would be determined on a GAAP basis. If we accept this argument, total assets have to be computed assuming trade date accounting as required by GAAP and the test on 9/21/2011 (assuming trade date accounting would increase gross assets by $50,000) would result in the following:

9/21/2011

     
Gross assets

3,200,000

   

5%

160,000

   
       
       
Stock A

295,000

9.22%

 
Stock B

235,000

7.34%

 
Stock C

427,000

13.34%

 
Stock D

425,000

13.28%

 
Stock E

140,000

 

4.33%

Notes F,G & H (3 securities, 1 issuer)

195,000

6.09%

 
       
  1,717,000

49.28%

 

Accordingly, if gross assets are defined for testing purposes as they are for GAAP purposes, immediately after the acquisition of the securities in question on 9/21/2011, the Fund would pass the test, in that it does meet both conditions in 851(d)(1) and relief would apply.

So what is the correct answer, can trade date accounting and the resulting higher amount of gross assets be used when performing diversification testing for purposes of the exception in IRC 851(d)(1)? Unfortunately the tax code is not clear enough on the subject to allow for a definitive “yes.” However, as presented above, a reasonable case for this position can be made. Ultimately, the decision will be up to the Fund’s management.

There are other interesting aspects of the IRC code section 851(d)(1) exception that are worthy of mention. For example, the exception clearly states that failure will result only if the “discrepancy” (i.e. the difference between the actual percentage of “bad assets” and 50% of gross assets) is “wholly or partly” the result of an acquisition. This would appear to mean that a failure would result if a “bad asset” security purchase either puts a fund over 50% non-diversified or merely increases the percentage by which a fund is already over 50% non-diversified. For example, suppose a Fund had in excess of 50% of its gross assets invested in 5% plus securities at the end of quarter 1, but after each purchase, the collective percentage of “bad assets” was under 50%, it would still clearly pass diversification testing under the IRC 851(d)(1) exception for that quarter. If during quarter 2, it made no additional purchases, it would continue to pass as of the end of quarter 2, even if its non-diversified percentage continues to be over 50%. If, however, during quarter 2 it purchases another 5% plus position, it presumably would fail at the end of quarter 2, since the “discrepancy” would be “partly” the result of the quarter 2 purchase. One can therefore conclude that once a fund is in an over 50% non-diversified posture it cannot make a purchase of another “bad asset” and expect to avail itself of the exception.

Finally, it is not clear from the applicable code sections whether a fund availing itself of the exception must pass the 50% test immediately after each purchase of a 5% plus security or only after the last purchase of a 5% plus security during the quarter. A more conservative approach would be to conclude that it must pass after each purchase.

This exception allowing for relief from asset diversification test failures can be complicated and comes with certain unanswered questions. We hope that this case study will help further your understanding of how the exception operates.

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