Investment Company Notebook
In Challenging Times, An Option For Funds To Retain Cash
Given the current COVID-19 crisis and its economic impact, it’s possible that some Regulated Investment Companies (“RICs”) could be exploring ways to retain their cash. The shareholder distribution requirements of IRC Section 851, however, remain, and it is highly unlikely Treasury or the IRS would ever grant relief in this area.
There is a solution based on current law that could allow for a RIC to meet its distribution requirement via a partial distribution of the RIC’s own stock. The fund could meet its distribution requirement and get a dividends paid deduction (“DPD”) while retaining a substantial amount of the cash (discussed below).
In response to the credit crisis of 2008, the IRS highlighted this method by issuing multiple temporary Revenue Procedures (“Rev. Proc.”) that provided guidance for how a RIC could utilize this provision. While the Revenue Procedures were temporary, it did set the precedent that this is an accepted method of accounting.
After the expiration of the temporary Revenue Procedures, the IRS was receiving multiple Private Letter Rulings (“PLRs”) from RICs looking to continue to utilize this method. In response, the IRS issued Rev. Proc. 2017-45, which sets forth specific guidance to meet the safe harbor requirements.
Current LawIRC Section 305(a) generally excludes distributions of stock of a corporation made by that corporation to its shareholders from gross income. Section 305 does contain the below exceptions:
- If at the election of any of the shareholders, the distribution is payable either in its stock or in property 1
- If the distribution has the result of the receipt of property by some shareholder (cash), and an increase in the proportionate interests of other shareholders (stock) 2
In either of the above exceptions, to the extent the corporation has sufficient earning and profits (“E&P”), the stock dividends would be included in gross income of the shareholder and more importantly would be eligible for Dividends Paid Deduction (“DPD”) for the RIC.
Rev. Proc. 2017-45
The purpose of this Rev. Proc. is to establish a Safe Harbor for RICs to take advantage of the exceptions in Section 305 without having to request a PLR from the IRS. Unlike its predecessors, Rev. Proc. 2017-45 does not include an expiration date, which is a positive development.
Unfortunately, the scope and requirements of the Safe Harbor are very complicated. Here, we provide a high-level overview of the requirements. It is important that you consult with your tax advisor to ensure you meet these requirements.
- The RIC must be considered publicly offered (defined below)
- The distribution declaration must state that each shareholder must have a Cash or Stock Election
- The Cash Limitation Percentage cannot exceed 20% of the total distribution
- Every shareholder who is not an Excess Cash Claimant (defined below) receives entire elected amount of cash
- If the aggregate cash elected amount does not exceed the overall cash limitation, every shareholder receives an amount of cash equal to their elected amount
- If the aggregate cash elected amount does exceed the cash limitation, then the Excess Cash Claimants receive an amount of cash equal to their proportionate claim relative to the total Excess Cash Claimants
Publicly Offered RIC: A RIC that has shares that are continuously offered pursuant to a public offering and traded on an established securities market, or held by no fewer than 500 persons at all times during the taxable year 3
Excess Cash Claimant: Any shareholder whose elect cash percentage exceeds the Cash Limitation Percentage.
Assuming the requirements above are met and the fund has sufficient E&P, the IRS will treat a stock distribution as eligible for a DPD.
One important item to note,however, is that for funds that have a Dividend Reinvestment Plan (“DRIP”), the stock received by the shareholder pursuant to that DRIP is treated as received in exchange for cash. As such, they are treated as cash for purposes of calculating the limitation.
The application of Rev. Proc. 2017-45 could be a useful tool for RICs to retain cash during this period of hardship. During the 2008 credit crisis, the cash limitation percentage was 10% as opposed to 20%, and the request has been made from the Industry to temporarily reduce the percentage to 10% again. The expectation is that this will be granted.
To reiterate, the calculation to ensure the fund is meeting the safe harbor requirements is complex and should not be undertaken without sufficient care. Please reach out to us or consult your tax advisor if this is an option that you would like to pursue.
1.) IRC Section 305(b)(1)
2.) IRC Section 305(b)(2)
3.) IRC Section 67(c)(2)(B)